47080 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

5The increment used by the specialists for

autoquoting, however, must be an increment that is

available for quotation on the exchange by all

members.

6See Securities Exchange Act Release No. 38156

(January 10, 1997), 62 FR 2415 (January 16, 1997),

order approving reduction in the minimum

quotation size for Nasdaq market makers in fifty

Nasdaq/NM securities (‘‘NASD Pilot’’). A list of the

50 Nasdaq/NM securities is located on the Nasdaq

web site (www.nasdaq.com).

7See Securities Exchange Act Release No. 38851

(July 18, 1997), 62 FR 39565 (July 23, 1997),

approving the extension of the NASD Pilot for a

minimum quotation size of 100 shares in 50

Nasdaq/NM securities until December 31, 1997.

8See Securities Exchange Act Release Nos. 38513

(April 15, 1997), 62 FR 19369 (April 21, 1997);

38872 (July 24, 1997), 62 FR 40879 (July 30, 1997),

(notices of request to expand the number of Nasdaq/

NM securities to 150).

9 15 U.S.C. § 78s(b)(12).

10 17 CFR 200.30-3(a)(12).

1 15 U.S.C. 78s(b)(1).

2 17 CFR 240.19b–4.

3On July 15, 1997, the NASD filed Amendment

No. 1 to the proposed rule change. On July 23, 1997,

the NASD filed Amendment No. 2 to the proposed

rule change. On August 28, 1997, the NASD filed

Amendment No. 3 to the proposed rule change.

Amendment No. 1 made several changes to the

proposed rule language and the rule filing. See

letter from John Ramsay, Deputy General Counsel,

NASD Regulation, Inc. (‘‘NASD Regulation’’) to

Katherine A. England, Assistant Director,

Commission, dated July 11, 1997. The changes

made by Amendment No. 1 are incorporated into

and published in this notice. Amendment No. 2

makes a technical change to Amendment No. 1. See

letter from John Ramsay, NASD Regulation to

Katherine A. England, Commission, dated July 22,

1997. Amendment No. 3 states that the NASD Board

of Governors has reviewed the proposed rule

change and that no other action by the NASD is

necessary for Commission consideration of the rule

proposal. See letter from John Ramsay, NASD

Regulation to Katherine A. England, Commission,

dated August 27, 1997.

The Commission, therefore, has

determined to permanently approve, on

an accelerated basis, the proposed rule

change permitting a CHX specialist to

autoquote in increments as determined

by the specialist from time to time.5

The Commission believes it is

reasonable for the CHX to determine

that for competitive reasons it will not

continue to require its specialists to

maintain a minimum quotation size of

1000 shares in certain Nasdaq/NM

securities when Nasdaq market makers’

in those securities are permitted a

minimum quotation size, for proprietary

quotes, of 100 shares.6 The Commission

notes, however, that it has not approved

the NASD Pilot on a permanent basis

nor has it determined that it should

continue past December 31, 1997.7 The

Commission is, therefore, approving the

CHX proposal on a pilot basis equal to

the limitations of the Nasdaq market

makers; 50 securities and until

December 31, 1997. Because Nasdaq

market makers have been quoting a

minimum of 100 shares for the 50

Nasdaq/NM securities in the NASD

Pilot since January, 1997, the

Commission is approving this part of

the proposal on an accelerated basis to

allow CHX specialists to also reduce the

minimum quotation size in those 50

Nasdaq/NM securities.

The Commission is deferring approval

of the proposal to permit CHX

specialists to reduce the quotation

minimum in an additional 100 Nasdaq/

NM securities until comments on the

proposal are received and the

Commission takes action on the NASD’s

proposal to expand the NASD Pilot by

100 securities.8

For the foregoing reasons, the

Commission finds good cause for

approving the proposed rule change, in

part, prior to the thirtieth day after date

of publication of notice of filing thereof

in the Federal Register.

It is therefore ordered, pursuant to

Section 19(b)(2) of the Act,9 that the

proposed rule change (SR–CHX–97–3)

be, and hereby is, approved.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.10

Jonathan G. Katz,

Secretary.

[FR Doc. 97–23601 Filed 9–4–97; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–38993; File No. SR–NASD–

97–35]

Self-Regulatory Organizations; Notice

of Filing of Proposed Rule Change by

the National Association of Securities

Dealers, Inc. Relating to the Regulation

of Non-Cash Compensation in

Connection With the Sale of

Investment Company Securities and

Variable Contracts

August 29, 1997.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’)1, and Rule 19b–4 2 thereunder,

notice is hereby given that on May 7,

1997,3 the National Association of

Securities Dealers, Inc. (‘‘NASD’’ or

‘‘Association’’) filed with the Securities

and Exchange Commission

(‘‘Commission’’) the proposed rule

change as described in Items I, II and III

below, which Items have been prepared

by the self-regulatory organization. The

Commission is publishing this notice to

solicit comments on the proposed rule

change from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

The NASD is filing a proposed rule

change to NASD Conduct Rules 2820

and 2830 relating to the regulation of

non-cash compensation in connection

with the sale of investment company

securities and variable contracts. Below

is the text of the proposed rule change.

Proposed new language is italicized;

proposed deletions are in brackets.

Conduct Rules

2820. Variable Contracts of an

Insurance Company

(a) Application.

Unchanged.

(b) Definitions.

(1)–(2) Unchanged.

(3) The terms ‘‘affiliated member,’’

‘‘compensation,’’ ‘‘cash compensation,’’

‘‘non-cash compensation’’ and ‘‘offeror’’

as used in paragraph (h) of this Section

shall have the following meanings:

‘‘Affiliated Member’’ shall mean a

member which, directly or indirectly,

controls, is controlled by, or is under

common control with a non-member

company.

‘‘Compensation’’ shall mean cash

compensation and non-cash

compensation.

‘‘Cash compensation’’ shall mean any

discount, concession, fee, service fee,

commission, asset-based sales charge,

loan, override, or cash employee benefit

received in connection with the sale and

distribution of variable contracts.

‘‘Non-cash compensation’’ shall mean

any form of compensation received in

connection with the sale and

distribution of variable contracts that is

not cash compensation, including but

not limited to merchandise, gifts and

prizes, travel expenses, meals and

lodging.

‘‘Offeror’’ shall mean an insurance

company, a separate account of an

insurance company, an investment

company that funds a separate account,

any adviser to a separate account of an

insurance company or an investment

company that funds a separate account,

a fund administrator, an underwriter

and any affiliated person (as defined in

Section 2(a)(3) of the Investment

Company Act of 1940) of such entities.

(c)–(g).

Unchanged.

(h) Member Compensation.

In connection with the sale and

distribution of variable contracts:

(1) Except as described below, no

associated person of a member shall

accept any compensation from anyone

other than the member with which the

person is associated. This requirement
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47081

4The current annual amount fixed by the Board

of Governors in $100.

will not prohibit arrangements where a

non-member company pays

compensation directly to associated

persons of the member, provided that:

(A) the arrangement is agreed to by

the member;

(B) the member relies on an

appropriate rule, regulation, interpretive

release, interpretive letter, or ‘‘noaction’’ letter issued by the Securities

and Exchange Commission that applies

to the specific fact situation of the

arrangement;

(C) the receipt by associated persons

of such compensation is treated as

compensation received by the member

for purposes of NASD rules; and

(D) the recordkeeping requirement in

subparagraph (h)(3) is satisfied.

(2) No member or person associated

with a member shall accept any

compensation from an offeror which is

in the form of securities of any kind.

(3) Except for items as described in

subparagraphs (h)(4) (A) and (B), a

member shall maintain records of all

compensation received by the member

or its associated persons from offerors.

The records shall include the names of

the offerors, the names of the associated

persons, the amount of cash, the nature

and, if known, the value of non-cash

compensation received.

(4) No member or person associated

with a member shall directly or

indirectly accept or make payments or

offers of payments of any non-cash

compensation, except as provided in

this provision. Notwithstanding the

provisions of subparagraph (h)(1), the

following non-cash compensation

arrangement are permitted:

(A) Gifts that do not exceed an annual

amount per person fixed periodically by

the Board of Governors 4 and are not

preconditioned on achievement of a

sales target.

(B) An occasional meal, a ticket to a

sporting event or the theater, or

comparable entertainment which is

neither so frequent nor so extensive as

to raise any question of propriety and is

not preconditioned on achievement of a

sales target.

(C) Payment or reimbursement by

offerors in connection with meetings

held by an offeror or by a member for

the purpose of training or education of

associated persons of a member,

provided that:

(i) the recordkeeping requirement in

subparagraph (h)(3) is satisfied;

(ii) associated persons obtain the

member’s prior approval to attend the

meeting and attendance by a member’s

associated persons is not

preconditioned by the member on the

achievement of a sales target or any

other incentives pursuant to a non-cash

compensation arrangement permitted

by subparagraph (h)(4)(D);

(iii) the location is appropriate to the

purpose of the meeting, which shall

mean an office of the offeror or the

member, or a facility located in the

vicinity of such office, or a regional

location with respect to regional

meetings;

(iv) the payment or reimbursement is

not applied to the expenses of guests of

the associated person; and

(v) the payment or reimbursement by

the offeror is not preconditioned by the

offeror on the achievement of a sales

target or any other non-cash

compensation arrangement permitted

by subparagraph (h)(4)(D).

(D) Non-cash compensation

arrangements between a member and its

associated persons or a non-member

company and its sales personnel who

are associated persons of an affiliated

member, provided that:

(i) the member’s or non-member’s

non-cash compensation arrangement, if

it includes variable contracts, is based

on the total production of associated

persons with respect to all variable

contracts distributed by the member;

(ii) the non-cash compensation

arrangement requires that the credit

received for each variable contract is

equally weighted;

(iii) no unaffiliated non-member

company or other unaffiliated member

directly or indirectly participates in the

member’s or non-member’s organization

of a permissible non-cash compensation

arrangement; and

(iv) the recordkeeping requirement in

subparagraph (h)(3) is satisfied.

(E) Contributions by a non-member

company or other member to a non-cash

compensation arrangement between a

member and its associated persons,

provided that the arrangement meets

the criteria in subparagraph (h)(4)(D).

* * * * *

2830. Investment Company Securities

(a) Application.

Unchanged.

(b) Definitions.

(1) [‘‘Associated person of an

underwriter,’’ as used in paragraph (1),

shall include an issuer for which an

underwriter is the sponsor or a principal

underwriter, any investment adviser to

such issuer, or any affiliated person (as

defined in Section 2(a)(3) of the

Investment Company Act of 1940) of

such underwriter, issuer, or investment

adviser.] The terms ‘‘affiliated member,’’

‘‘compensation,’’ ‘‘cash compensation,’’

‘‘non-cash compensation’’ and ‘‘offeror’’

as used in paragraph (l) of this section

shall have the following meanings:

‘‘Affiliated Member’’ shall mean a

member which, directly or indirectly,

controls, is controlled by, or is under

common control with a non-member

company.

‘‘Compensation’’ shall mean cash

compensation and non-cash

compensation.

‘‘Cash compensation’’ shall mean any

discount, concession, fee, service fee,

commission, asset-based sales charge,

loan, override or cash employee benefit

received in connection with the sale and

distribution of investment company

securities.

‘‘Non-cash compensation’’ shall mean

any form of compensation received in

connection with the sale and

distribution of investment company

securities that is not cash

compensation, including but not limited

to merchandise, gifts and prizes, travel

expenses, meals and lodging.

‘‘Offeror’’ shall mean an investment

company, an adviser to an investment

company, a fund administrator, an

underwriter and any affiliated person

(as defined in Section 2(a)(3) of the

Investment Company Act of 1940) of

such entities.

(2)–(10) Unchanged.

* * * * *

(c)–(k).

Unchanged.

* * * * *

(l) [Dealer Concessions] Member

Compensation.

[(1) No underwriter or associated

person of an underwriter shall offer, pay

or arrange for the offer or payment to

any other member in connection with

retail sales or distribution of investment

company securities, any discount,

concession, fee or commission

(hereinafter referred to as ‘‘concession’’)

which:]

[(A) is in the form of securities of any

kind, including stock, warrants or

options;]

[(B) is in a form other than cash (e.g.,

merchandise or trips), unless the

member earning the concession may

elect to receive cash at the equivalent of

no less than the underwriter’s cost of

providing the non-cash concession: or]

[(C) is not disclosed in the prospectus

of the investment company. If the

concessions are not uniformly paid to

all dealers purchasing the same dollar

amounts of securities from the

underwriter, the disclosure shall

include a description of the

circumstances of any general variations

from the standard schedule of

concessions. If special compensation

arrangements have been made with
47082 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

5The current annual amount fixed by the Board

of Governors is $100.

individual dealers, which arrangements

are not generally available to all dealers,

the details of the arrangements, and the

identities of the dealers, shall also be

disclosed.]

[(2) No underwriter or associated

person of an underwriter shall offer or

pay any concession to an associated

person of another member, but shall

make such payment only to the

member.]

[(3)(A) In connection with retail sales

or distribution of investment company

shares, no underwriter or associated

person of an underwriter shall offer or

pay to any member or associated person,

anything of material value, and no

member or associated person shall

solicit or accept anything of material

value, in addition to the concessions

disclosed in the prospectus.]

[(B) For purposes of this paragraph

(l)(3), items of material value shall

include but not be limited to:]

[(i) gifts amounting in value to more

than $50 per person per year.]

[(ii) gifts or payments of any kind

which are conditioned on the sale of

investment company securities.]

[(iii) loans made or guaranteed to a

non-controlled member or person

associated with a member.]

[(iv) wholesale overrides

(commissions) granted to a member on

its own retail sales unless the

arrangement, as well as the identity of

the member, is set forth in the

prospectus of the investment company.]

[(v) payment or reimbursement of

travel expenses, including overnight

lodging, in excess of $50 per person per

year unless such payment or

reimbursement is in connection with a

business meeting, conference or seminar

held by an underwriter for

informational purposes relative to the

fund or funds of its sponsorship and is

not conditioned on sales of shares of an

investment company. A meeting,

conference or seminar shall not be

deemed to be of a business nature

unless: the person to whom payment or

reimbursement is made is personally

present at, or is en route to or from, such

meeting in each of the days for which

payment or reimbursement is made; the

person on whose behalf payment or

reimbursement is made is engaged in

the securities business; and the location

and facilities provided are appropriate

to the purpose, which would ordinarily

mean the sponsor’s office.]

[(C) For purposes of this paragraph

(l)(3), items of material value shall not

include:]

[(i) an occasional dinner, a ticket to a

sporting event or the theater, or

comparable entertainment of one or

more registered representatives which is

not conditioned on sales of shares of an

investment company and is neither so

frequent nor so extensive as to raise any

question of propriety.]

[(ii) a breakfast, luncheon, dinner,

reception or cocktail party given for a

group of registered representatives in

conjunction with a bona fide business or

sales meeting, whether at the

headquarters of a fund or its

underwriter or in some other city.]

[(iii) an unconditional gift of a typical

item of reminder advertising such as a

ballpoint pen with the name of the

advertiser inscribed, a calendar pad, or

other gifts amounting in value to not

more than $50 per person per year.]

[(4) The provisions of this subsection

(1) shall not apply to:]

[(A) Contracts between principal

underwriters of the same security.]

[(B) Contracts between the principal

underwriter of a security and the

sponsor of a unit investment trust which

utilizes such security as its underlying

investment.]

[(C) Compensation arrangements of an

underwriter or sponsor with its own

sales personnel.]

In connection with the sale and

distribution of investment company

securities:

(1) Except as described below, no

associated person of a member shall

accept any compensation from anyone

other than the member with which the

person is associated. This requirement

will not prohibit arrangements where a

non-member company pays

compensation directly to associated

persons of the member, provided that:

(A) the arrangement is agreed to by

the member:

(B) the member relies on an

appropriate rule, regulation, interpretive

release, interpretive letter, or ‘‘noaction’’ letter issued by the Securities

and Exchange Commission or its staff

that applies to the specific fact situation

of the arrangement;

(C) the receipt by associated persons

of such compensation is treated as

compensation received by the member

for purposes of NASD rules; and

(D) the recordkeeping requirement in

subparagraph (l)(3) is satisfied.

(2) No member or person associated

with a member shall accept any

compensation from an offeror which is

in the form of securities of any kind.

(3) Except for items described in

subparagraphs (l)(5) (A) and (B), a

member shall maintain records of all

compensation received by the member

or its associated persons from offerors.

The records shall include the names of

the offerors, the names of the associated

persons, the amount of cash, the nature

and, if known, the value of non-cash

compensation received.

(4) No member shall accept any cash

compensation from an offeror unless

such compensation is described in a

current prospectus of the investment

company. When special cash

compensation arrangements are made

available by an offeror to a member,

which arrangements are not made

available on the same terms to all

members who distribute the investment

company securities of the offeror, a

member shall not enter into such

arrangements unless the name of the

member and the details of the

arrangements are disclosed in the

prospectus. Prospectus disclosure

requirements shall not apply to cash

compensation arrangements between:

(A) principal underwriters of the same

security; and

(B) the principal underwriter of a

security and the sponsor of a unit

investment trust which utilizes such

security as its underlying investment.

(5) No member or person associated

with a member shall directly or

indirectly accept or make payments or

offers of payments of any non-cash

compensation, except as provided in

this provision. Notwithstanding the

provisions of subparagraph (l)(1), the

following non-cash compensation

arrangements are permitted:

(A) Gifts that do not exceed an annual

amount per person fixed periodically by

the Board of Governors 5 and are not

preconditioned on achievement of a

sales target.

(B) An occasional meal, a ticket to a

sporting event or the theater, or

comparable entertainment which is

neither so frequent nor so extensive as

to raise any question of propriety and is

not preconditioned on achievement of a

sales target.

(C) Payment or reimbursement by

offerors in connection with meetings

held by an offeror or by a member for

the purpose of training or education of

associated persons of a member,

provided that:

(i) the recordkeeping requirement in

subparagraph (l)(3) is satisfied;

(ii) associated persons obtain the

member’s prior approval to attend the

meeting and attendance by a member’s

associated persons is not

preconditioned by the member on the

achievement of a sales target or any

other incentives pursuant to a non-cash

compensation arrangement permitted

by subparagraph (l)(5)(D);

(iii) the location is appropriate to the

purpose of the meeting, which shall
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47083

mean an office of the offeror or the

member, or a facility located in the

vicinity of such office, or a regional

location with respect to regional

meetings;

(iv) the payment or reimbursement is

not applied to the expenses of guests of

the associated person; and

(v) the payment or reimbursement by

the offeror is not preconditioned by the

offeror on the achievement of a sales

target or any other non-cash

compensation arrangement permitted

by subparagraph (l)(5)(D).

(D) Non-cash compensation

arrangements between a member and its

associated persons or a non-member

company and its sales personnel who

are associated persons of an affiliated

member, provided that:

(i) the member’s or non-member’s

non-cash compensation arrangement, if

it includes investment company

securities, is based on the total

production of associated persons with

respect to all investment company

securities distributed by the member;

(ii) the non-cash compensation

arrangement requires that the credit

received for each investment company

security is equally weighted;

(iii) no unaffiliated non-member

company or other unaffiliated member

directly or indirectly participates in the

member’s or non-member’s organization

of a permissible non-cash compensation

arrangement; and

(iv) the recordkeeping requirement in

subparagraph (l)(3) is satisfied.

(E) Contributions by a non-member

company or other member to a non-cash

compensation arrangement between a

member and its associated persons,

provided that the arrangement meets

the criteria in subparagraph (l)(5)(D).

* * * * *

II. Self-Regulatory Organization’s

Statement of the Purpose of, and

Statutory Basis for the Proposed Rule

Change

In its filing with the Commission, the

NASD 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.

NASD Regulation has prepared

summaries, set forth in Sections A, B,

and C below, of the most significant

aspects of such statements.

A. Self-Regulatory Organization’s

Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule

Change

Introduction

The NASD is proposing to amend

Rules 2820 and 2830 of the NASD

Conduct Rules to establish new rules

applicable to the sale of variable

contracts (‘‘Variable Contracts Rule’’)

and revise existing rules applicable to

the sale of investment company

securities (‘‘Investment Company

Rule’’).

Generally, the proposed rule change

would: (1) Adopt definitions of the

terms ‘‘affiliated member,’’

‘‘compensation,’’ ‘‘cash compensation,’’

‘‘non-cash compensation,’’ and

‘‘offeror’’; (2) prohibit, except under

certain circumstances, associated

persons from receiving any

compensation from anyone other than

the member with which the person is

associated; (3) require that members

maintain records of compensation

received by the member or its associated

persons from offerors; (4) with respect to

the Investment Company Rule, prohibit

receipt by a member of cash

compensation from the offeror unless

such arrangement is described in the

current prospectus; (5) retain the

prohibition, with respect to the

Investment Company Rule, against a

member receiving compensation in the

form of securities; and (6) prohibit, with

certain exceptions, members and

persons associated with members from

directly or indirectly accepting or

paying any non-cash compensation in

connection with the sale of investment

company and variable contract

securities.

The exceptions from the non-cash

compensation prohibition would

permit: (1) Gifts of up to $100 per

associated person annually; (2) an

occasional meal, ticket to a sporting

event or theater, or comparable

entertainment; (3) payment or

reimbursement for training and

education meetings held by a brokerdealer or a mutual fund or insurance

company for the purpose of educating

associated persons of broker-dealers, as

long as certain conditions are met; (4)

in-house sales incentive programs of

broker-dealers for their own associated

persons; (5) sales incentive programs of

mutual funds and insurance companies

for the associated persons of an

affiliated broker-dealer; and (6)

contributions by any non-member

company or other member to a brokerdealer’s permissible in-house sales

incentive program.

Background

The proposed rule change is the latest

in a series of NASD proposals designed

to control the use of non-cash

compensation in connection with a

public offering of securities. Previous

rule amendments established

restrictions on non-cash compensation

in connection with transactions in

direct participation program securities,

real estate investment trusts, and

corporate debt and equity offerings.

In developing the proposed rule

change, the staff and NASD

Regulations’s Investment Companies

Committee, the Insurance Affiliated

Member Committee, and the Variable

Insurance Products Committee (a

successor to the Insurance Affiliated

Committee) (collectively, the

‘‘Committees’’) have considered the

current environment in which

investment company and variable

contract securities are sold. The NASD

believes that the increased use of noncash compensation for the sale of

investment company and variable

contract securities heightens the

potential for loss of supervisory control

over sales practices and increase the

perception on inappropriate practices,

which may result in a loss of investor

confidence. The NASD also believes

that the increased use of non-cash

compensation creates significant pointof-sale incentives that may compromise

the requirement to match the

investment needs of the customer with

the most appropriate investment

product. The NASD determined,

therefore, that the adoption of

limitations on non-cash compensation is

appropriate at this time.

In 1992, the NASD submitted to the

Commission proposed rule change SR–

NASD–92–36, which proposed

recordkeeping and disclosure

requirements on the receipt of non-cash

compensation in connection with the

sale of investment company and

variable contract securities. As as result

of Commission staff concerns regarding

the proposal, the NASD withdrew SR–

NASD–92–36 in April 1994. In March

1995, the NASD submitted SR–NASD–

95–10 to the Commission, which

proposed substantive prohibitions on

the receipt of non-cash compensation in

connection with sale of investment

company and variable contract

securities. The NASD withdrew that

proposal in 1995. In December 1995, the

NASD submitted to the Commission

proposed rule change SR–NASD–95–61,

which proposed substantive

prohibitions regarding non-cash

compensation and incentive-based cash

compensation in connection with the
47084 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

6Release No. 34–37374 (June 26, 1996), 61 FR

35822 (July 8, 1996.)

7The NASD issued a Notice to Members

regarding the regulation of payment and receipt of

cash compensation incentives in August 1997. The

comment period expires on October 15, 1997. See

NASD Notice to Members 97–50 (August 1997).

8 In Notice to Members 94–14 (March 1994), the

NASD clarified the obligations of members in

complying with the compensation disclosure

requirements for investment companies in

subparagraph (l)(1)(C) to Conduct Rule 2830. See

also NASD Notice to Members 94–41 (May 1994).

sale of investment company and

variable contract securities. SR–NASD–

95–61 was published by the

Commission for public comment on July

8, 1969.6

SR–NASD–96–51 raised significant

issues among commenters regarding the

nature and treatment of certain

incentive-based cash compensation

arrangements, in particular those cash

compensation arrangements of

insurance-affiliated member firms.

NASD Regulation has prepared a

summary of the comments, which is

attached as Exhibit A. Most of the

commenters opposed the proposed

provisions to regulate incentive-based

cash compensation. In response to the

commenters, the NASD determined to

delete those provisions proposing to

impose substantive prohibitions

regarding incentive-based cash

compensation. Therefore, the NASD has

withdrawn SR–NASD–95–61 and has

replaced it with this proposed rule

change, which does not contain

provisions imposing substantive

regulations on the receipt of cash

compensation arrangements.

Nevertheless, the NASD is aware of a

broad range of cash compensation

practices by which investment company

and variable contract issuers or their

affiliates provide various incentives and

rewards to individual broker-dealers

and their registered representatives for

selling the issuers’ products. NASD staff

believes that various cash incentive

compensation practices, which create an

incentive to favor one product over

another, also may compromise the

ability of securities salespersons to

render advice and services that are in

the best interests of customers. The

NASD has determined to solicit

comment pertaining to these issues

before proposing any new rules to

require either disclosure or substantive

regulation of cash compensation for the

sale of investment company and

variable contract securities.

Accordingly, the NASD intends to issue

a Request for Comment that would

inquire primarily about the nature of

various cash compensation

arrangements and structures within the

mutual fund and variable product

industries, the potential harms and

benefits of such arrangements and

structures, and the appropriate

regulatory approach to such

arrangements and structures.7 The

Request for Comment will explore

issues such as: (1) The nature of various

cash compensation arrangements,

particularly within the mutual fund and

variable product industries (such as

‘‘revenue sharing’’ and payments of

differential compensation for

proprietary versus non-proprietary

products); (3) the current best practices

being followed by each industry

regarding cash compensation

arrangements; (3) the potential harms

and benefits of such arrangements; and

(4) the appropriate regulatory approach

to such arrangements (such as

disclosure versus substantive

prohibitions).

In addition, the Request for Comment

will explore the general applicability of

such issues mentioned above across all

product lines to address broader issues

regarding compensation practices,

including disparate compensation

practices in general, how fare NASD

rules regarding incentive-based

compensation should reach, the effects

at point-of-sale of incentive-based

compensation in general, and which

regulatory approaches, if any, would be

appropriate in addressing disparate

compensation practices.

Description of the Proposed Rule

Change

The current requirements of

paragraph (l) of the Investment

Company Rule regulate the disclosure

and form of dealer concessions between

principal underwriters and retail dealers

of investment company securities.

These provisions prohibit dealer

concessions in the form of securities,

require that members may elect to

receive cash in lieu of the receipt of

non-cash compensation, and prohibit

the payment of concessions directly to

associated persons of a member. The

provisions also set forth requirements

with respect to the disclosure of

compensation arrangements between

underwriters and dealers in the

investment company’s prospectus.8

With respect to the regulation of

variable contract securities, the

requirements of the Variable Contract

Rule currently do not contain similar

provisions regulating dealer

concessions. Thus, the proposed

amendments to the Investment

Company Rule would modify current

requirements, and the proposed

amendments to the Variable Contracts

Rule would establish new requirements

that address compensation

arrangements between an offeror and

any member participating in the

distribution of the company’s securities.

The discussion below address each

proposed provision in the Investment

Company Rule and its counterpart in

the Variable Contracts Rule.

Definitions. ‘‘Affiliated Member’’: The

NASD is proposing to adopt a definition

of the term ‘‘affiliated member’’ for both

the Investment Company and Variable

Contract Rules to include a member that

directly or indirectly controls, is

controlled by, or is under common

control with a non-member company.

The term is used in the sections of the

proposed rule change that address

incentive compensation arrangements in

order to identify a common type of

relationship existing in the investment

company and variable contracts

industries whereby a non-member owns

or controls one or more subsidiary

broker-dealer member firms used for

underwriting and/or wholesale and

retail distribution services.

‘‘Compensation’’: For ease of

reference in appropriate paragraphs of

the proposed rules, the NASD is also

proposing to include in the Variable

Contracts Rule and the Investment

Company Rule a new definition of

‘‘compensation’’ to mean ‘‘cash

compensation and non-cash

compensation,’’ and to amend the

appropriate paragraphs in the proposed

rule language accordingly.

‘‘Cash Compensation’’: As proposed

to be defined in both the Investment

Company and Variable Contracts Rules,

this term would include any discount,

concession, fee, service fee,

commission, asset-based sales charge,

loan, override or cash employee benefit

received in connection with the sale and

distribution of investment company

securities or variable contracts. This

term would encompass compensation

arrangements currently covered under

the Investment Company Rule in

subparagraph (l)(1), to Conduct Rule

2830 as well as asset-based sales charges

and service fees as currently defined in

subparagraphs (b) (8) and (9) of the

Investment Company Rule. As a result,

the proposed new term would apply to

all compensation arrangements that

would be covered under the current

provisions of the Investment Company

Rule, with the addition of asset-based

sales charges and service fees. The

proposed new term also includes cash

employee benefits to make clear that

certain payments of ordinary employee

benefits as part of an overall

compensation package are not included

in the definition of non-cash

compensation.
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47085

9There are no current similar terms in the

Variable Contracts Rule.

10The term is significantly different from the term

‘‘person associated with a member’’ as used

throughout the NASD’s rules and regulations. Any

reference to persons associated with an NASD

member firm is defined by the definition of ‘‘person

associated with a member’’ or ‘‘associated person of

a member’’ in Article I, Section (m) to the NASD

By-Laws.

11Closed-end management companies are also

subject to the prohibition on non-cash

compensation contained in the Corporate Financing

Rule in Conduct Rule 2710.

12The exception is not, however, restricted to

these situations, but is intended to be available in

any situation where a member relies on any

appropriate rule, regulation, interpretive release or

applicable ‘‘no-action’’ position issued by the

Commission that applies to the specific fact

situation of the arrangements.

13See Release No. 34–8389 (August 29, 1968)

(‘‘Distribution of Variable Annuities by Insurance

Companies, Broker-Dealer Registration and

Regulation Problems under the Securities Exchange

Act of 1934’’). The Commission stated that no

question will be raised by Commission staff

regarding an arrangement where a life insurance

company makes commission payments directly to

its life insurance agents who are also persons

associated with the insurance company’s subsidiary

broker-dealer, so long as: (1) such payments are

made as a purely ministerial service and properly

reflected on the books and records of the brokerdealer; (2) a binding agreement exists between the

insurance company and the broker dealer that all

books and records are maintained by the insurance

company as agent on behalf of the broker-dealer and

are preserved in conformity with the requirements

of Rules 17a–3 and 17a–4 under the Act; (4) all such

books and records are subject to inspection by the

Commission in accordance with Section 17(a) of the

Act; and (5) the subsidiary broker-dealer has

assumed full responsibility for the securities

activities of all persons engaged directly or

indirectly in the variable annuity operation.

14See no-action letters issued by Division of

Market Regulation, Commission to Traditional

Equinet (January 8, 1992) and Mariner Financial

Services (December 16, 1988). The Traditional

Equinet and Mariner Financial Services letters

requesting Commission no-action include

references to other Commission no-action letters.

‘‘Non-Cash Compensation’’: This

definition is proposed to be identical in

applicability to both the Investment

Company and Variable Contract Rules,

and would encompass any form of

compensation received by a member in

connection with the sale and

distribution of investment company and

variable contract securities that is not

cash compensation, including but not

limited to merchandise, gifts and prizes,

travel expenses, meals and lodging.

Thus, the definition of ‘‘non-cash

compensation’’ encompasses

reimbursement for costs incurred by a

member or person associated with a

member in connection with travel,

meals and lodging.

‘‘Offeror’’: The NASD is proposing to

define the term ‘‘offeror’’ in the

Investment Company Rule to include an

investment company, an adviser to an

investment company, a fund

administrator, an underwriter and any

affiliated person of such entities, and in

the Variable Contracts Rule to include

an insurance company, a separate

account of an insurance company, an

investment company that funds a

separate account, any advisor to a

separate account of an insurance

company or an investment company

that funds a separate account, a fund

administrator, an underwriter and any

affiliated person of such entities. With

the exception of ‘‘fund administrator,’’

the enumerated entities included in the

proposed definition of ‘‘offeror’’ in the

Investment Company Rule are currently

included in the definition of ‘‘associated

person of an underwriter,’’ which is

proposed to be deleted.9 The definition

of the term ‘‘associated person of an

underwriter’’ in the Investment

Company Rule, which is proposed to be

deleted, encompasses the issuer, the

underwriter, the investment advisor to

the issuer, and any affiliated person of

such entities.10 The term ‘‘affiliated

person’’ in the proposed definition of

‘‘offeror’’ is defined in accordance with

Section 2(a)(3) of the 1940 Act. The term

‘‘underwriter’’ is defined in Section

2(a)(40) of the 1940 Act and is intended

to reference the principal underwriter

through which the investment and

insurance company distributes

securities to participating dealers for

sale to the investor.

Regulation of the receipt of cash and

non-cash compensation. Introduction—

The NASD is proposing to adopt as

paragraph (l) to the Investment

Company Rule (replacing the current

provisions of that section) and

paragraph (h) of the Variable Contracts

Rule new provisions governing the

receipt of non-cash compensation by

members and associated persons of

members. The proposed amendments

would be applicable to both variable

annuity and variable life products under

the Variable Contracts Rule. With

respect to the Investment Company

Rule, the proposed amendments would

be applicable to sales of securities of an

investment company registered under

the 1940 Act. Thus, the proposed rules

would be applicable to sales of

securities by a face-amount certificate

company, a unit investment trust, and

open-end and closed-end management

companies.11

The preamble to the new rules

provides that such compensation must

be received ‘‘in connection with the sale

and distribution’’ of investment

company or variable contract securities,

as applicable. The preamble is intended

to clarify that the provisions relate only

to cash and non-cash compensation

received in connection with the sale and

distribution of the security covered by

the rule, but not to other forms of

payment that are not related to sales and

distribution activities.

Subparagraphs (l)(1) and (h)(1):

Limitation on Receipt of Compensation

by Associated Persons, and Exception

From Limitations—The NASD is

proposing in new subparagraph (l)(1) of

the Investment Company Rule and new

subparagraph (h)(1) of the Variable

Contracts Rule generally to prohibit a

person associated with a member from

accepting any compensation from any

person other than the member with

which the person is associated. The

provision is based on current

subparagraph (l)(2) of the Investment

Company Rule.

An exception from this general

prohibition is proposed that would

allow the receipt of compensation by an

associated person directly from a nonmember company if: the member agrees

to the arrangement, the receipt is treated

as compensation received by the

member for purposes of NASD rules, the

recordkeeping requirement in the

proposed rule change is satisfied, and,

the member relies on an appropriate

rule, regulation, interpretive release,

interpretive letter or applicable ‘‘noaction’’ letter issued by the Commission

or its staff that applies to the specific

fact situation of the arrangement. Also,

the proposed rule change treats such

direct payments to associated persons as

compensation in order to ensure that the

member views such payments in the

same manner as payments made directly

to the member for purposes of NASD

rules and posts such payments to the

member’s books.

The proposed exception is

particularly intended to reflect those

situations where Commission

interpretations permit direct payments

by the insurance company to associated

persons as a ‘‘ministerial service’’ or

because state insurance law prohibits

payments of commissions on variable

products to a broker-dealer.12 The

exception reflects the view of the

Commission staff that under certain

circumstances such commission

payments to associated persons may be

made by a life insurance company

acting on behalf of a subsidiary brokerdealer.13 The NASD also notes that the

Commission has issued a number of

‘‘no-action’’ letters permitting, among

other things, associated persons of

members to receive compensation for

the sale of variable contract products

from a license corporate insurance agent

acting on behalf of one or more

insurance companies.14
47086 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

15See, e.g., no action letter issued by the Division

of Market Regulation, Commission to Commission

to The Mutual Benefit Life Insurance Company

(December 20, 1984), and other Commission noaction letters cited herein.

16See no action letter issued by Division of

Market Regulation, Commission to Chubb Securities

Corporation (November 24, 1993). 17See supra note 7.

Although the need to recognize such

direct payments arose in connection

with the sale of variable contract

products, the Investment Company Rule

includes the same exception in order to

recognize Commission no-action letters

that permit an insurance company to

establish a commission account as a

ministerial service to make payments of

commission overrides for sales of

insurance and investment company

securities products.15 Moreover, the

language of the proposed provision in

the Investment Company and Variable

Contract Rules permits such direct

payments by any ‘‘non-member

company’’ in order to recognize that any

entity may be permitted to make such

payments.16

Subparagraph (1)(2): Securities as

Compensation—The NASD is proposing

to retain as new subparagraph (1)(2) of

the Investment Company Rule the

provision currently in subparagraph

(l)(1)(A) that prohibits members and

associated persons of members from

receiving compensation in the form of

securities of any kind. The NASD is also

proposing a similar provision as

subparagraph (2) to paragraph (h) of

Rule 2820.

Subparagraphs (l)(3) and (h)(3):

Recordkeeping Requirement—The

NASD is proposing to adopt as new

paragraph (l)(3) of the Investment

Company Rule and paragraph (h)(3) of

the Variable Contracts Rule the general

requirement that members must

maintain records of all compensation,

cash and non-cash, received from

offerors. The records must include the

names of the offerors, the names of the

associated persons, and the amount of

cash and the nature and, if known, the

value of non-cash compensation

received.

With respect to the requirement that

the actual value of non-cash

compensation be recorded, if it is

known, the NASD believes that the

value of a non-cash item is usually not

known where unaffiliated third parties

contribute to a training and education

program sponsored by a member. In this

case, it would be appropriate to include

only a description of the nature of the

non-cash item of compensation. In

comparison, the value of non-cash items

provided by member firms and/or their

affiliates is generally readily known or

determinable.

The requirement in the proposed rule

to maintain a record of the ‘‘nature’’ of

the non-cash compensation received

requires that the member disclose, in

addition to the names of the offerors and

the names of the associated persons,

whether the non-cash compensation is

paid in connection with a sales

incentive program or a training and

education meeting. The NASD further

expects such records to retain all

information necessary to determine that

the rule is being complied with. Thus,

for example, with respect to non-cash

compensation received by a member for

a training and education meeting, it

would be expected that the records

would include information

demonstrating that the requirements of

a training and education meeting were

complied with, including the date and

location of the meeting, the fact that

attendance at the meeting is not

conditioned on the achievement of a

previously specified sales target, the fact

that payment is not applied to the

expenses of guests of associated persons

of the member, and any other

information required to enable NASD

Regulation to determine compliance

with the rule.

The recordkeeping requirement is not

applicable to two types of de minimis

non-cash compensation allowable under

subparagraphs (l)(5) (A) and (B) to the

Investment Company Rule and

subparagraphs (h)(4) (A) and (B) of the

Variable Contracts Rule, discussed more

fully below under the exceptions to the

prohibition on non-cash compensation.

Subparagraph (l)(4): Prospectus

Disclosure of Cash Compensation—The

NASD is proposing to adopt a new

subparagraph (l)(4) in the Investment

Company Rule a requirement that

prohibits the acceptance of cash

compensation by a member from an

offeror unless such compensation is

disclosed in a prospectus. In the case

where special cash compensation

arrangements are made available by an

offeror to a member, which

arrangements are not made available on

the same terms to all members to

distribute the securities, the disclosure

shall include the name of the recipient

member and the details of the special

arrangements. This requirement is

similar to the current requirement in

subparagraph (l)(1)(C) of the Investment

Company Rule to disclose all

compensation in the prospectus, but has

been modified to reference only ‘‘cash

compensation’’ because non-cash

compensation is proposed to be

prohibited in a manner that would

obviate the need for disclosure of any

such non-cash compensation.

The proposed rule change includes

two exceptions from the prospectus

disclosure requirement in the

Investment Company Rule. The two

exceptions in new subparagraphs (l)(4)

(A) and (B) track the language in current

subparagraphs (l)(4) (A) and (B) of the

Investment Company Rule, with minor

language changes for clarification. These

two provisions provide an exception

from disclosure for compensation

arrangements between: (1) principal

underwriters of the same security; and

(2) the principal underwriter of a

security and the sponsor of a unit

investment trust that utilizes such

security as its underlying investment.

By their terms, these provisions describe

arrangements that would not trigger the

proposed recordkeeping requirements.

The NASD will reconsider the

appropriateness of prospectus

disclosure in light of the Commission’s

recent initiatives for simplified

prospectus disclosure as well as the

responses to NASD’s publication of a

Request for Comment on cash

compensation issues.17

Subparagraphs (l)(5) and (h)(4):

Prohibition on Non-Cash

Compensation—The NASD is proposing

to adopt as new subparagraph (l)(5) to

the Investment Company Rule and new

subparagraph (h)(4) to the Variable

Contracts Rule a general prohibition,

with certain exceptions, on the receipt

of non-cash compensation in connection

with the sale and distribution of

investment company and variable

contract securities. The new provision

would prohibit a member or person

associated with a member from directly

or indirectly accepting or making

payments or offers of payments of any

non-cash compensation, unless the

payment is specifically excepted. The

proposed rule change contains several

exceptions from the general prohibition

on the receipt of non-cash

compensation.

Subparagraphs (l)(5) (A) and (B) and

(h)(4) (A) and (B): The NASD is

proposing to adopt exceptions that

would permit an associated person to

accept from a person other than his or

her member-employer: (1) gifts that do

not exceed an annual amount per

person, currently $100 per person, fixed

periodically by the Board of Governors;

and (2) an occasional meal, a ticket to

a sporting event or the theater, or

comparable entertainment for persons

associated with a member and, if

appropriate their guests, which is

neither so frequent nor so extensive as

to raise any question of propriety. These

provisions are based on the current
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47087

18A member holding a training or education

meeting for its associated persons (in comparison to

the associated persons of another member) would

not be required to comply with this provision if the

member does not receive a payment or

reimbursement from an offeror for the expenses of

the meeting. In any event, the member would not

be prohibited from permitting offerors to make a

presentation at the meeting.

provisions of subparagraphs (l)(3)(B)(i)

and (C)(i) of the Investment Company

Rule. Since such gifts and entertainment

are considered non-cash items, they are

not required to be disclosed in the

prospectus. In addition, these two forms

of non-cash compensation are

specifically excepted from the

recordkeeping requirement of the

proposed rules.

The proposed provisions would

require that the receipt of such non-cash

items not be preconditioned on the

achievement by the associated person of

a sales target. This language replaces the

current requirement in subsection

(l)(3)(B)(v) of the Investment Company

Rule that entertainment ‘‘not be

conditioned on sales of shares of

investment companies.’’ The revised

language is intended to clarify that such

gifts and entertainment are permitted to

be provided as recognition for past sales

or as encouragement for future sales, but

shall not be part of an incentive program

or plan that requires that the recipient

reach a specific sales goal as a prior

condition to receive the entertainment

or gift.

The proposed exceptions for $100

gifts and entertainment are intended to

permit the continuation of longestablished, normal business practices,

involving benefits with relatively small

value such that they are unlikely to

impact overall compensation incentives.

The exceptions also recognize that

NASD Regulation has not detected or

been aware of any history of abuses in

connection with the receipt of such

items of compensation by associated

persons of a member firm in connection

with the sale of investment company or

variable contract securities.

Subparagraphs (l)(5)(C) and

29(h)(4)(C): The NASD is also proposing

an exception to the prohibition on noncash compensation for training and

education meeting. This exception is

contained in subparagraph (l)(5)(C) of

the Investment Company Rule and

subparagraph (h)(4)(C) of the Variable

Contracts Rule. The proposed exception

would, under certain conditions, permit

payment or reimbursement by offerors

in connection with meetings held by the

offeror or by a member for the purpose

of training or education of associated

persons of a member.18 It is not unusual

for offerors to pay for such meetings in

order to discuss their products and to

reimburse certain expenses related to

meetings held by members in exchange

for the opportunity to make a

presentation to the associated persons of

the member on a particular training or

education topic.

This provision is intended to continue

to permit members and offerors to hold

training or education meetings for

associated persons of one or more

members, where an offeror or a number

of offerors pay for or reimburse the

expenses of the meeting. Since

investment company and variable

contract products are continuously

offered, it is particularly important that

associated persons receive education

opportunities with respect to the

investment company and variable

contract industries generally, updates

on any portfolio changes or structural

changes to a current product, and

explanations of new products.

Since the proposed prospectus

disclosure provision only requires

disclosure of cash compensation, the

proposed exception would not trigger

the disclosure requirements because the

payment or reimbursement of expenses

by an offeror for a member’s training

and education meeting is considered to

be non-cash compensation.

The NASD anticipates that the agenda

of a bona fide training or education

meeting will reflect the business

purpose of the meeting. In order to

establish circumstances that will

encourage such a business purpose, the

NASD is proposing that the exception

for training or education meetings be

subject to five conditions that are

intended to ensure that the meeting is

held for the purpose of training and

education and is not, in fact, a

prohibited non-cash sales incentive.

The first condition is that the

payment or reimbursement by offerors

in connection with such meetings is

subject to the proposed recordkeeping

requirement in subparagraph (l)(3) of

the Investment Company Rule and

subparagraph (h)(3) of the Variable

Contracts Rule. This provision is

designed to ensure that information on

such payments and reimbursements is

maintained in the records of the

member and, therefore, capable of

examination and regulatory oversight by

NASD Regulation.

The second condition is that

associated persons must obtain the

member’s prior approval to attend the

meeting. It is anticipated that members

will establish a procedure so that their

records reflect that appropriate approval

has been provided to associated persons

in connection with such meetings. This

provisions assists members in

maintaining supervisory control over

their associated persons. Moreover, the

second condition also requires that

attendance by the member’s associated

persons may not be based by the

employer-member on the achievement

of a sales target or any other incentives

that would otherwise be permitted

under subparagraphs (l)(5)(D) or

(h)(4)(D) of the proposed rule. That

provision would permit non-cash

compensation arrangements between a

member and its associated persons or

between a non-member company and its

sales personnel who are associated

persons of an affiliated member, as more

fully discussed below. This condition is

intended to ensure that the member

does not treat a training or education

meeting as a non-cash incentive item.

The provision is not, however, intended

to prevent a member from designating

persons to attend a meeting held by the

member or by an offeror to recognize

past performance or encourage future

performance, so long as attendance at

the meeting is not earned through a

member’s in-house sales incentive

program, through the sales incentive

program of a member’s non-member

affiliate, or through the achievement of

a sales target.

The third condition is that the

location of the meeting must be

appropriate to its purpose. A showing of

appropriate purpose is demonstrated

where the location is the office of the

offeror or the member, or a facility

located in the vicinity of such office. In

order to address meetings where the

attendees are from a number of offices

in a region of the country, the meeting

location may be in a regional location.

The fourth condition is that the

payment or reimbursement by an offeror

must not be applied to the expenses of

guests of the associated person.

The fifth and final condition is that

the payment or reimbursement by the

offeror must not be conditioned by the

offeror on the achievement of a sales

target or any other non-cash

arrangement permitted by

subparagraphs (l)(5)(D) or (l)(4)(D) of the

proposed rule. This requirement is

intended to ensure that the offeror

making the payment or reimbursement

does not participate in any manner in a

member’s decision as to which

associated persons will attend a

member’s or offeror’s meeting.

The fifth condition and the second

provision, which prohibits a member

from basing the associated person’s

attendance at a training or education

meeting on achievement of a previously

specified sales target or a permissible inhouse non-cash incentive arrangement,

collectively are intended to clarify that
47088 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

19As set forth above, arrangements by insurance

companies for compensating salespersons for

variable product sales are generally part of a total

compensation package based on the sale of nonsecurities insurance products as well as variable

contract securities.

20See Report of the Committee on Compensation

Practices (April 10, 1995) (‘‘Tully Report’’), p. 13.

attendance at a training or education

meeting by an associated person is

permitted to be approved by a member

as a recognition for past sales, but shall

not be part of a member’s or offeror’s

incentive program or plan that requires

that the recipient or the member reach

a sales goal as a prior condition to

attending the training or education

meeting.

Subparagraphs (l)(5) (D) and (E) and

(h)(4) (D) and (E): The NASD is

proposing to adopt exceptions from the

prohibition on non-cash compensation

that will permit: (1) Non-cash

compensation arrangements between a

member and its associated persons; (2)

non-cash compensation arrangements

between a non-member company and its

sales personnel who are associated

persons of an affiliated member; and (3)

contributions by a non-member

company or other member to a non-cash

compensation arrangement between a

member and its associated persons.

The three permissible arrangements

are subject to four conditions: (1) The

member’s or non-member’s non-cash

compensation arrangement, if it

includes investment company or

variable product securities, must be

based on the total production of

associated persons with respect to all

investment company or variable product

securities distributed by that member;

(2) the credit received for each

investment company or variable

contract security must be equally

weighted; (3) no unaffiliated nonmember company or other unaffiliated

member may directly or indirectly

participate in the member’s or nonmember’s organization of a permissible

non-cash compensation arrangement;

and (4) the recordkeeping requirements

must be satisfied. However, the

applicability of the total production and

equal weighting requirements to

variable contract securities does not

require that variable annuity and

variable life products be combined in

the same incentive arrangement.

Because of the substantially different

commission structures that presently

apply in the case of each product, the

NASD intends that the equal weighting

requirement would apply separately to

variable annuity and variable life

products.

The proposed rule change is intended,

in part, to address non-cash

compensation that acts as a significant

incentive at the point-of-sale to the

investor. Such non-cash incentive

programs, in addition to creating the

potential to undermine the supervisory

control of the member over its

associated person sales practices when

offered by third parties, also may

motivate salespersons at the point-ofsale to recommend a specific product on

the basis of the incentive rather than a

desire to meet the investment needs of

the customer.

The NASD’s proposed rule change,

therefore, attempts to limit non-cash

sales incentives regarding the sale of

one investment company security over

another or one variable contract security

over another to situations where such

non-cash incentives do not contain the

potential to impact the point-of-sale

recommendation by an associated

person to a customer or to undermine

the supervisory control of the member

firm with respect to its associated

person’ sales of these products.

The proposed rule change is designed

to eliminate the point-of-sale impact of

non-cash sales incentives on the sales

practices of an associated person with

respect to the sale of investment

company and variable contract

securities by prohibiting third-party

non-cash sales incentive programs and

by requiring that all securities of the

same product type be included in the

member’s (or its affiliate’s) in-house

incentive program and be equally

weighted. The proposed rule change,

therefore, would prohibit a third-party

offeror from conducting a non-cash sales

incentive program for associated

persons of member firms, in that such

programs provide incentives at the

point-of-sale to influence a salesperson

to sell the proprietary products of the

offeror to the exclusion of other

products and have the potential to

undermine the supervisory control of

members with respect to their

associated persons. The proposed rule

change would, however, continue to

permit non-cash incentive programs by

a member for its associated persons or

by an insurance or investment company

for the associated persons of an

affiliated member, under the four

conditions discussed more fully below.

This provision is based on a

determination that non-cash

compensation arrangements that are

internal to the employer-employee

relationship do not raise the same

supervisory concerns that are present in

the compensation arrangements

between a non-member and the

associated persons of unaffiliated

broker-dealers selling its product.

As noted above, another exception

permits a non-member affiliate to grant

non-cash incentives to the associated

persons of its affiliated broker-dealer,

subject to the same conditions described

above. Particularly in the life insurance

industry, non-member insurance

companies may hold non-cash sales

incentive programs for their sales

personnel who are also associated

persons of the non-member’s affiliated

broker-dealer and are licensed to sell

both non-securities insurance products

and variable contract securities. It is

common practice, for example, for a

member’s parent life insurance

company to award ‘‘points’’ for the sale

of all insurance products—including

securities—toward attendance at the

insurance company’s annual

‘‘leadership conference.’’ 19 Moreover,

the exception recognizes that, as a

practical matter, an insurance company

or investment company affiliated with a

broker-dealer is in a position through

intra-corporate transfers to contribute to

and through its relationship to affect the

structure of its affiliated broker-dealer’s

in-house incentive compensation

program.

The permissible in-house non-cash

arrangements by a member or its

affiliate are subject, moreover, to the

first two conditions described above

(that the program is based on total

production and credit for different

products is equally weighted). These

conditions help to ensure that a noncash sales incentive earned by a

member’s associated person is received

on a delayed basis and does not

influence the associated person’s pointof-sale relationship with the investor.

Thus, the proposed provisions would

allow for sales incentive programs based

on such measures as overall gross

production, new accounts opened or

assets under management. Such

measures are not precluded by the

proposed rule language and are based

on the same intent to align the interests

of associated persons, broker-dealers

and investors.20

In proposing the second condition,

requiring equal weighting, the NASD

recognizes that differential payouts at

all levels is common industry practice

and that current methods for

determining compensation credits vary,

including measurements based on gross

production to the firm or net

commissions to the associated person.

Either practice, as well as other

arrangements, would be acceptable

under the proposed rule so long as the

concept of ‘‘equal weighting’’ is met and

not skewed by disparate commission,

payout or re-allowance structures for

individual products. It is believed that

these requirements will ensure that
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47089

21The provision would also permit a member’s

affiliate to contribute to the member’s in-house noncash incentive program. 22See supra note 20.

members and their affiliates selling

proprietary investment company and

variable contracts products do not

structure in-house non-cash

arrangements that are biased in favor of

any one specific product or proprietary

products as a group.

A member’s or its affiliate’s non-cash

compensation arrangement is also

subject to the restriction that no

unaffiliated non-member entity (usually

an offeror) or another member can

participate directly or indirectly in the

member’s or its affiliate’s organization

of a permissible non-cash sales

incentive program. This provision is

intended to ensure that third-party

offerors are not involved in and do not

influence the organization of a

permissible non-cash sales incentive

program by a member or a member’s

affiliate. The restriction on participation

is not, however, intended to prevent a

non-member company from making a

presentation on its products at a

member’s or its affiliate’s in-house sales

incentive meeting at the member’s or

affiliate’s request.

Finally, the non-cash incentive

program of a member or its affiliate for

a member’s associated persons is also

subject to the recordkeeping

requirements of the proposed rule.

Thus, where the member or its

associated persons is in receipt of

payments or non-cash sales incentives

from its affiliated entity, such payments

or non-cash sales incentives must be

recorded on the books and records of

the member firm.

The NASD is also proposing in

subparagraph (l)(5)(E) of the Investment

Company Rule and subparagraph

(h)(4)(E) of the Variable Contracts Rule

that any non-member entity (usually an

offeror) or another member continue to

be permitted to contribute to any

member’s in-house non-cash sales

incentive program, subject to the same

four conditions identified above. This

provision is intended to permit thirdparty offerors, and their affiliates, to

contribute to the non-cash incentive

program of a member in order to benefit

the associated persons of the member

that sell the offeror’s securities.21 The

proposed rule change does not,

similarly, permit third-party entities to

make contributions to the non-cash

incentive program of an affiliate of a

member because such non-member

affiliates are not subject to the

recordkeeping requirements of the

proposed rule change. Thus,

contributions by third-parties for a noncash incentive program for associated

persons of a member firm may only be

made directly to the member.

Relationship of the proposed rule

change to the Tully Report. The Tully

Report reviewed industry compensation

practices in connection with the sale of

all forms of securities for associated

persons of members, identified conflicts

of interests inherent in such practices

and identified the ‘‘best practices’’ used

in the industry to eliminate, reduce or

mitigate such conflicts of interest.22 The

rule change proposed herein is limited

to addressing certain compensation

issues only in connection with the sale

of investment company securities and

variable contracts. The NASD believes

that the proposed rule change is

consistent with the characteristics of

‘‘best practices’’ identified in the Tully

Report in that the requirements in the

proposed rule for the receipt of noncash incentives address the point-of-sale

impact of such incentives on the sales

practices of an associated person,

thereby helping to better align the

interests of associated persons, brokerdealers and investors with respect to the

sale of investment company securities

and variable contracts.

The NASD recognizes, however, that

this proposal does not address many

significant issues raised by that report

and, as noted, will seek public comment

on the appropriate regulatory treatment

of other types of compensation

arrangements. Nonetheless, the NASD

believes that this proposal should not be

delayed by consideration of these other

compensation issues in that this

proposal addresses non-cash

arrangements that have been generally

identified and regarded as potentially

abusive practices.

Proposed implementation of new

rules. The NASD is proposing that the

amendments to the Investment

Company and Variable Contracts Rules

be implemented in the following

manner. The proposed rule change will

be effective on the date stated in a

Notice to Members announcing

Commission approval, which date will

be no later than 60 days after

Commission approval. As of that date,

members will be required to comply

with the proposed rule change. With

respect to the non-cash and cash sales

incentive provisions, no new sales

incentive programs may be commenced

after the announced effective date. Sales

incentive programs that are on-going on

the date of effectiveness would be

permitted to continue for a period not

to exceed six months following the

announced effective date. Thus, during

the six-month implementation period,

no new incentive programs could

commence, although sales could be

applied to existing incentive programs.

Non-cash and cash sales incentives

earned by associated persons would be

permitted to be received for a period not

to exceed twelve months following the

expiration of the six-month

implementation period.

Statutory Basis

The NASD believes that the proposed

rule change is consistent with the

provisions of Section 15A(b)(6) of the

Act, which require that Association

adopt and amend its rules to promote

just and equitable principles of fair

trade, and generally provide for the

protection of investors and the public

interest in that the proposed rule change

is designed: (1) to adopt new regulations

with respect to the sales of variable

contract securities in Rule 2820 of the

NASD Conduct Rules to regulate the

direct payment of compensation to

associated persons by persons other

than the member with which a person

is associated with, to establish

recordkeeping requirements; and to

regulate the receipt of non-cash

compensation by members and their

associated persons; and (2) to amend

current regulations with respect to the

sale of investment company securities

in Rule 2830 of the NASD Conduct

Rules to clarify the circumstances under

which associated persons may receive

direct payments of compensation from

persons other than the member with

which a person is associated with, to

establish recordkeeping requirements, to

retain current disclosure requirements

and a prohibition on the receipt of

securities as compensation, and to

regulate the receipt of non-cash

compensation by members and their

associated persons. Moreover, the

proposed rule change is designed to

minimize the point-of-sale impact of

non-cash sales incentives on the

recommendations of associated persons

to their customers with respect to the

sale of investment company and

variable contract securities and

eliminate any potential that third-part

non-cash incentives may undermine the

supervisory control of the member with

respect to their associated persons,

which would increase the possibility for

the perception of impropriety that may

result in a loss of investor confidence.

B. Self-Regulatory Organization’s

Statement on Burden on Competition

The NASD does not believe that the

proposed rule change will result in any

burden on competition that is not
47090 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

23SR–NASD–95–61 contained a summary of

comments in response to the publication by the

NASD of Notice to Members 94–67 (August 22,

1994). Those comments, and the NASD’s response

thereto, are not reproduced in this rule filing, but

are contained in the Commission’s publication of

SR–NASD–95–61. See supra note 6. 24See supra note 7. 25 17 CFR 200.30–3(a)(12).

necessary or appropriate in furtherance

of the purposes of the Act, as amended.

C. Self-Regulatory Organization’s

Statement on Comments on the

Proposed Rule Change Received From

Members, Participants, or Others

The proposed rule change has not

been published for member comment.

However, SR–NASD–95–61 was

published by the Commission for

comment on July 8, 1996.23 SR–NASD–

95–61 requested public comment on

amendments to Rules 2820 and 2830 of

the NASD’s Conduct Rules that, among

other things, would have prohibited the

acceptance, directly or indirectly, of

non-cash compensation, with certain

exceptions, and would have also

prohibited the acceptance, directly or

indirectly, of cash compensation

preconditioned on achieving a sales

target (incentive-based cash

compensation provision), with certain

exceptions. The exceptions to the

incentive-based cash compensation

provision would have permitted

members to accept cash compensation

preconditioned on achieving a sales

target so long as the compensation,

among other things: (1) was based on

total sales of all investment company or

variable contract securities offered; and

(2) required that the credit received for

each investment company or variable

contract security sold carries equal

weight in structuring the compensation

arrangement.

The Commission received comment

letters from 30 commenters, 7 of whom

were supportive, 18 of whom were

opposed, and 5 of whom were neither

for nor against the proposal. A summary

of the comments is attached as Exhibit

A. Most of the commenters were

insurance-affiliated members that

distributed proprietary variable

insurance products of their parent

insurance companies and also offered

some non-proprietary variable insurance

products to accommodate their

customers. In addition to ordinary sales

commissions, sales of proprietary

products often generate other incentivebased cash compensation such as

contributions from the parent insurance

company to its sales agents’ pension

plan, health insurance plan, 401(k) plan,

and similar fringe benefits. Most

commenters regarded the total sales and

equal credit requirements of the

incentive-based cash compensation

provision as very problematic, and

stated that the requirements appear to

mandate equal treatment of incentive

compensation paid for both proprietary

and non-proprietary products.

Commenters stated that there is not

enough profit margin built in to nonproprietary products to fund equal

compensation. The commenters also

stated that it would be too difficult

operationally and practically to

implement such an equal treatment

system. The commenters also stated that

the internal differential compensation

practices of member firms ought not to

be regulated by the NASD.

The Investment Companies

Committee (‘‘ICC’’), at its meeting on

October 2, 1996, and the Insurance

Affiliated Committee (‘‘IAC’’), at its

meeting on October 8, 1996, reviewed

and discussed the comment letters. Both

Committees concluded that the

incentive-based cash compensation

provisions in SR–NASD–95–61 were

generally intended by the NASD to

prohibit the circumvention of the noncash prohibition by monetizing the noncash payment, and were not intended to

regulate broader compensation and

recognition programs of insurance

companies. However, both Committees

also agreed with the commenters that

the language of the incentive-based cash

compensation provision was capable of

being interpreted broadly and voted

unanimously to either amend the

incentive-based cash compensation

provision to clarify its intended scope or

delete the provision in its entirety.

In subsequent discussions, NASD staff

determined to delete the incentivebased cash compensation provision in

its entirety. In addition, because of the

complexity of issues regarding the

variety of cash compensation

arrangements in the mutual fund and

variable products industry, and the need

to explore the nature of these

arrangements more thoroughly, NASD

staff also determined to solicit the

Committees’ views on the publication of

a Request for Comment requesting

general comments on cash

compensation issues.24

The ICC, at its meeting on February

11, 1997, and the Variable Insurance

Products Committee (‘‘VIPC’’), a

successor to the IAC, at its meeting on

February 24, 1997, both agreed with the

views of NASD staff and voted

unanimously to amend the proposal by

deleting the cash compensation

provision and to issue the Request for

Comment on cash compensation issues.

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.

Persons making written submissions

should file six copies thereof with the

Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

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 at

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 File No.

SR–NASD–97–35 and should be

submitted by September 26, 1997.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.25

Jonathan G. Katz,

Secretary.

Exhibit A—NASD’s Summary of

Comments Received in Response to the

Publication of SR–NASD–95–61

Background

SR–NASD–96–51 requested public

comment on amendments to Rules 2830

and 2820 of the NASD’s Conduct Rules

(formerly, Article III, Sections 26 and

29, respectively, of the NASD Rules of

Fair Practice) that would revise existing

rules applicable to the sale of

investment company securities

(‘‘Investment Company Rule’’) and
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47091

establish new rules applicable to the

sale of variable contract securities

(‘‘Variable Contracts Rule’’). Generally,

the proposed rule change would, in

connection with the sale and

distribution of investment company

securities and variable contracts: (1)

adopt definitions of the terms ‘‘affiliated

member’’, ‘‘cash compensation’’, ‘‘noncash compensation’’ and ‘‘offeror’’; (2)

prohibit, except under certain

circumstances, associated persons from

receiving any compensation, cash or

non-cash, from anyone other than the

member with which the person is

associated; (3) required that members

maintain records of compensation

received by the member or its associated

persons from offerors; (4) with respect to

the Investment Company Rule, prohibit

receipt by a member of cash

compensation from the offeror unless

such arrangement in described in the

current prospectus; (5) retain the

prohibition, only with respect to the

Investment Company Rule, against a

member receiving compensation in the

form of securities; (6) prohibit, with

certain exceptions, members and

persons associated with members from

accepting, directly or indirectly, any

non-cash compensation in connection

with the sale of investment company

and variable contract securities; and (7)

prohibit, with certain exceptions, a

person associated with a member from

accepting, directly or indirectly, any

cash compensation in connection with

the sale of investment company and

variable contract securities.

The exceptions from the non-cash

compensation prohibition would

permit: (1) gifts of up to $100 per

associated person annually; (2) an

occasional meal, ticket to a sporting

event or theater, or entertainment for

associated persons and their guests; (3)

payment or reimbursement for training

and education meetings held by a

broker-dealer or a mutual fund or

insurance company for associated

persons of broker-dealers, as long as

certain conditions are met; (4) in-house

sales incentive programs of brokerdealers for their own associated persons;

(5) sales incentive programs of mutual

funds and insurance companies for the

associated persons of an affiliated

broker-dealer; and (6) contributions by

any non-member company or other

member to a broker-dealer’s permissible

in-house sales incentive program.

The exceptions from the cash

compensation prohibition would

permit: (1) in-house sales incentive

programs of broker-dealers for their own

associated persons; (2) sales incentive

programs of mutual funds and insurance

companies for the associated persons of

an affiliated broker-dealer; and (3)

contributions by any non-member

company or other member to a brokerdealer’s permissible in-house sales

incentive program.

The Commission received comment

letters from the following

commentators:

1. American Council of Life Insurance

2. American Council of Life Insurance

3. American Funds Distributors, Inc.

4. American General Securities

Incorporated

5. Banc One Corporation

6. BMA Financial Services, Inc.

7. Carillon Investments, Inc.

8. Cigna Financial Advisors, Inc.

9. Cova Financial Services Life

Insurance Company

10. The Equitable Life Assurance

Society of the United States

11. First Investors Corporation

12. Investment Company Institute

13. John Hancock Mutual Life Insurance

Company

14. John Hancock Mutual Life Insurance

Company

15. Locust Street Securities, Inc.

16. Merrill Lynch, Pierce, Fenner &

Smith Incorporated

17. M Financial Group

18. The Minnesota Mutual Life

Insurance Company

19. The Minnesota Mutual Life

Insurance Company

20. MML Investors Services, Inc.

21. National Life of Vermont

22. The New England

23. The Princor Financial Services

Corporation

24. Security Benefit Life Insurance

Company

25. Sunset Financial Services, Inc.

26. The Union Central Life Insurance

Company

27. Walnut Street Securities

28. WS Griffith and Co., Inc.

29. Investment Company Institute

30. SAFECO Life Insurance Company

Of the 30 commenters, 7 were

supportive (Comments 2, 3, 5, 10, 12,

16, 29), 18 were opposed (Comments 4,

6, 7, 8, 11, 13, 14, 18, 19, 20, 21, 23, 24,

25, 26, 27, 28, 30), and 5 were neither

for nor against the proposal (Comments

1, 9, 15, 17, 22).

General Comments

Those commenters supporting the

proposed rule generally applauded the

efforts of the NASD and the Commission

to provide consistent rules for the sale

of investment company securities and

variable annuity contracts, supported

sensible regulatory enhancements that

facilitate the ability of members to

execute compliance and supervisory

responsibilities, recognized that certain

non-cash practices may raise the

perception of impropriety and

potentially undermine the confidence of

investors, such as contests offering

lavish trips and expensive prizes, and

supported initiatives reasonably

targeted to reducing or eliminating

potential conflicts of interest in these

situations. Some of these commenters,

however, also stated that additional

work is necessary to ensure that the

proposed rules adequately meet the

needs expressed and are not overbroad

(Comments 2, 3, 5, 10, 12, 16).

The most common general criticism,

primarily from insurance-affiliated

members distributing proprietary

products through the career agency

system, was that the proposed rules

appear to mandate equal treatment of

both proprietary and non-proprietary

commission payments and/or cash and

non-cash compensation arrangements

for the sale of variable products and

mutual funds. According to the

commenters, this would, among other

things, restrict the ability of member

firms and their affiliated insurance

companies to pay higher commissions

for their proprietary products, give an

unfair advantage to broker-dealers that

do not manufacture their own variable

products, lead to the sale of only

proprietary variable products, lead to

the sale of only fixed insurance

products, produce an anti-competitive

environment, cause the demise of the

traditional insurance career agency

system, and conflict with the current

practice of treating career agents under

IRS rules as ‘‘statutory employees’’

when selling proprietary products and

‘‘independent contractors’’ when selling

non-proprietary products, thus requiring

fundamental changes to the

compensation structure within parent

life insurance companies who continue

to offer proprietary and non-proprietary

variable insurance contracts (Comments

4, 8, 10, 11, 13, 14, 17, 19, 20, 21, 22,

23, 24, 25, 26, 27, 28).

Specific Comments

Conflicts of Interest

Point of Sale Incentives

Some commenters stated that the

proposed rule overemphasized point-ofsale conflicts (Comments 10, 14, 17, 27).

One commenter disputed that non-cash

incentives are currently influencing a

salesperson’s product recommendation

at the point of sale and stated that

therefore the need for the proposed

changes does not exist (Comment 27).

Another commenter stated that there is

little in a proprietary sales force

distribution model that distributes an

overwhelmingly proprietary product
47092 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

line, particularly variable insurance

products, that seems to raise the

prospect of meaningful point-of-sale

conflicts, and that if the proposed rules

regulate the manner in which non-cash

incentives are awarded in situations

which don’t present a significant

conflict of interest, they represent in

inappropriate and unwarranted

regulatory intrusion into the internal

compensation arrangements between a

member and its associated persons

(Comment 10). Two commentators

stated that point-of-sale incentives for

variable products are mitigated by the

fact that agents selling variable

insurance products, as compared to

mutual funds, tend to receive a higher

percentage commission on premium

payments in the early years and to have

a greater expectation of future premium

payments that will result in additional

compensation in subsequent years

(Comment 14), and that since a portion

of the registered representative’s

compensation remains dependent upon

the continuance of the policy in force,

the agent has an intrinsic motivation to

place an appropriate and suitable

product at inception (Comment 17).

Disclosure

Other commenters argued that the

dangers of conflicts of interest at pointof-sale can be addressed through

disclosure (Comments 11, 17). One

commenter noted that the Commission

Release did not suggest that any actual

abuses have occurred that justify such

substantive regulation of in-house

incentive programs, and stated that even

assuming that in-house incentive

programs favoring proprietary products

created the ‘‘possibility’’ of a conflict of

interest, there is no explanation in the

Commission Release why disclosure of

possible conflicts would not be

sufficient to cure the problem (Comment

11). Another commenter stated that

complete prospectus disclosure of the

terms of any kind of incentive

compensation would provide the

customer with complete notice of the

incentives, is a far better solution to

NASD concerns regarding consumer

protection, and would accomplish the

NASD’s goals without the unintended

market impact the proposed rules will

have (Comment 17).

Supervision

Other commenters thought conflicts

of interest could be properly addressed

through supervision (Comments 6, 8).

One commenter stated that the proposed

rules are too restrictive and specific, and

do not adequately recognize the success

of members in existing control over

their associates and managing their

control environments in a manner that

sensibly balances legitimate business

objectives and potential conflicts of

interest (Comment 8). The same

commenter further stated that, unlike

direct participation program markets in

the 1980s, members are effectively

managing the supervisory issues

associated with the sale of investment

company securities and variable

contracts, and therefore the proposed

rules will have a negative impact on

these industries without concomitant

benefit. The commenter stated that the

Commission should return the proposed

rule to the NASD with the suggestion

that it be revised to eliminate most of

the specific limitations on conduct, and

instead emphasize (a) reliance on

members to properly control perceived

conflicts of interest, and (b) changes (if

any) necessary to enable the NASD to

supervise the performance of members

in exercising such control (Comment 8).

Unlevel Playing Field/Discriminatory

Impact

Variable Versus Fixed Insurance

Products

Some commenters stated that the

proposed rules create an unlevel playing

field between sellers of variable

contracts and sellers of traditional fixed

life insurance products. (Comments 4,

14, 17). One commenter stated that

since companies which only sell

traditional fixed insurance products are

free to provide whatever non-cash

compensation they wish, the

unintended result of the proposed rules

may be that insurance companies with

affiliated broker-dealers will request

that variable contracts offered by nonaffiliated companies be removed from

broker-dealers’ list of approved products

(Comment 4). Another commenter

stated that if the proposed rules are

adopted, many insurance companies

will limit their cash and non-cash

incentive compensation programs to

sales of non-variable insurance products

and registered reps interested in the

incentives offered by a particular

compensation program may encourage

the investor to purchase the nonvariable product irrespective of whether

that product is the most suitable

(Comment 14). Another commenter

stated that this unintended skewing

does not occur in investment company

securities since investment companies

do not have any unregistered funds

(Comment 17).

Discrimination Against Smaller Issuers

and Independent Insurance Agencies

One commenter stated that the

proposed rules will place small fund

groups which distribute through their

own in-house sales forces at a serious

economic disadvantage since they will

be required to give unaffiliated groups

equal access to their distribution

systems without having to share the

high costs or maintaining such systems

(Comment 11). Small fund groups with

captive sales forces will clearly suffer

because they will probably not have the

clout to demand fees for shelf space,

and their only alternative may be to take

unaffiliated funds off their shelves

altogether (Comment 11). If such fund

groups could not recover the costs of

training in-house sales representatives

by ‘‘encouraging’’ them to sell housebrand products, they would have little

incentive to invest in such training in

the first instance (Comment 11).

Another commenter stated that as the

rules are presently written, insurance

companies that have affiliated brokerdealer may implement and use non-cash

compensation incentives to reward their

captive brokerage agents while non-cash

compensation for independent agents is

prohibited, which unfairly

discriminates against the independent

agent, the independent broker-dealer,

and issuers who distribute their

products through independent brokerdealers (Comment 17). Thus, captive

agents have opportunities with regard to

compensation that independent agents

do not, which skews the marketplace

toward a limited line of products from

a single issuer, which may not be in the

client’s best interest (Comment 17).

Proprietary Versus Non-Proprietary

Products

Many commenters stated that the

proposed rules, by requiring insuranceaffiliated firms to ‘‘equally credit’’ sales

of all third party products, will force

insurance-affiliated firms selling

primarily proprietary products to either

deny its registered reps access to thirdparty products, sell such products at a

loss, or pay lower commissions for

proprietary products (Comments 10, 13,

19, 20, 21, 22, 23, 24, 25, 26, 27, 28).

Following are selected excerpts from

commenters.

(a) ‘‘Preconditioned on achieving a

sales target’’ and ‘‘equal credit.’’

One commenter stated that virtually

all broker-dealer commission schedules

provide for banded commissions, i.e.,

for all sales between $0 and $X, the

commission is 40%; for all sales

between $X and $Y the commission is

45%. Thus, all commissions are

‘‘preconditioned on a person achieving

a sales target’’ (Comment 20). The

commenter argues that therefore,

proposed subparagraph (h)(4) to Rule

2820, which provides that ‘‘no person
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47093

associated with a member shall accept

any cash compensation that is

preconditioned on such person

achieving a sales target,’’ literally

prohibits registered representatives from

accepting commissions for their sales

unless the commission schedule falls

within a specified exception of the rule.

The same commenter further argued

that subparagraph (h)(4) would mandate

that an insurer include within its overall

compensation plan not only

compensation from sales of the variable

contracts which it issues but also

compensation from the sales of all the

variable contracts which may be

distributed by its registered

representatives in its affiliated brokerdealer. The commenter concluded that

firms with proprietary products will be

unable to comply with the ‘‘equal

treatment’’ mandate of the proposed

rules and be forced to limit products to

only their proprietary products, which

would eliminate the incentive that

issuers now have to improve their

product design and/or administration so

as to allow them to pay out higher total

compensation. Thus, any superior profit

margins that an issuer may achieve

would be used not to provide incentives

for further sales of that product but to

supplement compensation on nonproprietary products or inferior

proprietary products. The commenter

stated that the proposed rules, if

adopted without further clarification,

would be inconsistent with longstanding insurance regulatory practices,

and give an unfair competitive

advantage to broker-dealers that do not

manufacture their own products

(Comment 20).

Another commenter stated that the

proposed rules require a member firm

which offers incentive-compensation on

proprietary products to provide

comparable incentives in connection

with the sale of non-proprietary

products, and the most likely means to

do so will be to reduce the base

commissions (i.e., the non-incentive

compensation) paid to registered

representatives for the sale of nonproprietary products. These savings in

base commission costs (i.e., the

additional portion of the dealer

concession retained by the member

firm) will then be used to provide

incentive compensation on nonproprietary products at the same level as

on proprietary products. Registered

representatives would therefore have an

even greater incentive to offer

proprietary products given the even

greater disparity in base compensation

payable between proprietary and nonproprietary products. Such an outcome

is also inconsistent with the stated

intention of the proposal. The simplest

means by which a member firm may

comply with the proposed rules is to

eliminate all non-proprietary products

from its list of products (Comment 19).

Another commenter stated that if a

captive dealer could no longer provide

incentive programs to its own reps

which focused on proprietary products,

it would be faced with the unfortunate

choice of becoming strictly captive or

being less able to earn a return on the

traditionally greater investment they

have made in their reps, as the benefit

of that investment unintentionally

accrues partly to outside product

providers (Comment 21).

Another commenter stated that if the

rules are adopted sales contests will be

held only to promote those products

whose issuers have the resources to

finance multiple contests or who sell

through captive agents. This situation

creates an advantage for large issuers

with the ability to finance the contest of

multiple broker-dealers (Comment 24).

Another commenter stated that the

proposed rules will have the opposite

effect than what is contemplated. The

proposed rules will require many

companies to make wholesale changes

in their compensation plans and in the

systems that support these plans, which

will cost millions of dollars. Instead,

many companies may decide to

disallow the sale of ‘‘non-proprietary’’

products, in effect limiting the

registered rep to one fund family and

one variable annuity contract (Comment

25).

(b) Anti-competitive effect.

One commenter stated that because

some members might only offer

proprietary products, clients of such

member firms would have a limited

number of products from which to

choose unless those clients were willing

to shop around among various brokers,

which would have a negative effect on

competition (Comment 13).

Another commenter stated that

because the resulting response by many

insurance company broker-dealers with

proprietary mutual funds, variable

annuities, and variable life insurance

will be to reduce or eliminate

availability of non-proprietary products,

investors will be subject to fewer

objective investment recommendations,

less portfolio diversification, and

recommendations of other possible non

suitable products not affected by the

proposal, e.g., fixed annuities and and/

or permanent insurance policies

(Comment 23).

Another commenter stated if the

proposed rules take effect, a number of

firms will out of necessity be forced to

only offer so-called proprietary

products. This would severely limit the

choice of products being offered to the

prospective purchaser by a particular

registered representative and necessitate

the potential purchaser of a product to

go through the time consuming process

of having to visit a number of registered

representatives (Comment 28).

(c) Effect on ‘‘statutory employee’’

compensation and ‘‘career agent’’

system.

One commenter stated that although

the proposed subparagraphs sections

(h)(4) and (1)(6) would appear to

mandate the equal treatment of both

proprietary and non-proprietary

commission payments for variable

products and investment companies, the

Internal Revenue Code makes this

virtually impossible for insuranceaffiliated companies utilizing the career

agency system. For such companies, the

commission and recognition programs

for their proprietary variable insurance

and annuity products are integrated into

the overall compensation plans for its

career agents. In accordance with

Section 3121(d)(3) of the Internal

Revenue Code, payment of commissions

of these proprietary variable insurance

products to full-time career agents is

treated as W–2 income to statutory

employees. Typically, such

commissions also generate contributions

from the parent insurance company to

the career agent’s pension plan, health

insurance plan, 401(k) plan, and similar

fringe benefits. Payments made to career

agents for sales of non-proprietary

products are, however, treated as 1099

income paid to independent contractors.

Accordingly, non-proprietary products

commissions are not, and cannot be,

incorporated into overall compensation

plans (Comment 20).

The same commenter further stated

that even if commissions from the sales

of non-proprietary variable products

could somehow be received by the

parent insurance company, it would

still be impractical to recognize them in

the parent’s compensation plans

because such products are not

manufactured by the proprietary issuer

and there has been no opportunity to

build appropriate margins into the

products to cover certain distribution

costs, particularly fringe benefit costs

(Comment 20).

Another commenter further stated

that the profit margins on third-party

products are insufficient to fund the

cost of providing ‘‘equal credit’’ toward

all benefits having production eligibility

criteria. As a result, if forced to provide

equal credit for the sale of nonproprietary variable products,

insurance-affiliated firms will be faced
47094 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

with the Hobson’s choice of either

denying its registered representatives

access to third-party products (to the

ultimate detriment of its customers), or

selling such products at a loss

(Comment 10).

The same commenter stated that to

the extent that the proposed rules bring

within the definition of ‘‘non-cash

compensation’’ (or otherwise purport to

regulate as incentive-based cash

compensation) items that traditionally

have been viewed as point-of-sale

incentives but instead as benefits

customarily afforded in the context of

an employer-employee relationship

(e.g., health and disability income

coverage, tuition reimbursement

programs, etc.), the result will be

regulation that is disruptive and unduly

burdensome, again without

meaningfully contributing to the

protection of investors (Comment 10).

Another commenter stated that agent

compensation is covered in collective

bargaining agreements between

insurance companies and career agents.

If certain forms of compensation are no

longer permitted with respect to

variable products under the terms of the

proposed rules, then collective

bargaining agreements may have to be

renegotiated (Comment 13).

Training and Education Limitations

Some commenters objected to the

limitations imposed on training and

education meetings (Comments 8, 20,

23, 24).

One commenter argued that, contrary

to the requirements of the proposed

rule, it is entirely appropriate to assess

eligibility for training and education

meetings based on achievement of sales

targets. Offerors have a legitimate

interest in limiting participation in such

meetings to representatives whose sales

activities reflects some minimal level of

interest in the offeror’s product. It is

unreasonable without substantial

justification to preclude offerors from

targeting representatives who have

exhibited an ability to market the

offeror’s product (Comment 8).

The same commenter also stated that

the proposed rules should not impose

artificial limits on ‘‘appropriate

locations’’ for training and education

meetings organized by offerors. Limiting

‘‘appropriate’’ to mean ‘‘an office of the

offeror or the member, or a facility

located in the vicinity of such office, or

a regional location with respect to

regional meetings’’ is unnecessary and

too rigid (Comment 8).

Another commenter similarly stated

that the limitations in the proposed

rules concerning the locations of

education/training meetings should be

relaxed, not increased. The proposed

rules mistakenly attempt to draw a link

between the purpose of a meeting (i.e.

education/training) and the location at

which such meeting is conducted (i.e.

office of the offeror or member). The

commenter suggested that the largely

irrelevant location requirements for

education/training meetings be

eliminated and replaced with a simple

requirement that the broker-dealer be

required to maintain documents (e.g.

agendas, attendance lists, etc.)

confirming the educational nature of the

meeting (Comment 20).

Another commenter stated that, if the

proposed rules are adopted, product

issuers will have no control over the

content of presentations made at

training and education conferences.

This shift in control of the sales

conference from the issuer to the broker

will result in the loss of an important

forum for issuers to educate

independent agents about the products

they sell (Comment 24).

Implementation

Some commenters requested that the

implementation period for the proposed

rules be extended (Comments 11, 13, 15,

27, 28).

One commenter stated that the sixmonth grace period for implementing

the rules is not long enough since many

sales contests cover a full year or more

than one year, and recommended

grandfathering all contests commenced

before the effective date of the rule

(Comment 11).

Other commenters stated that proper

implementation requires that contracts

between offerors and member firms will

have to be amended to include

provisions assuring compliance with the

new rules, systems will have to be

updated to track compensation of total

production, and, if repricing is

involved, approval by state insurance

departments may be necessary prior to

implementation. Such issues could

require up to 24 months to fully comply

with the proposed rules (Comments 13,

15, 27, 28).

Recommendations

A few commenters suggested changes

to the non-cash and cash incentive

provisions of the proposed rules

(Comments 2, 10, 16, 20, 22).

One commenter stated that the

inclusion of subparagraph (h)(4),

dealing with cash compensation

matters, was confusing because the

proposal and its release largely address

non-cash compensation rule

amendments (Comment 2). The

commenter stated that it did not

interpret subparagraph (h)(4) as an

attempt to establish new procedures

governing the receipt of cash

compensation by associated persons of

a broker-dealer, but as an effort to

prevent circumvention of non-cash

compensation practices by

‘‘monetizing’’ the compensation. The

commenter stated that subparagraph

(h)(4) could be construed to simply state

that broker-dealers may not do

indirectly what they are prohibited

directly from doing in Rule 2820, and

recommended the substitution of this

concept for subparagraph (h)(4)

(Comment 2).

Another commenter stated that the

problems resulting from the equal

weighting requirement can be addressed

through the adoption of a de minimis

exception to the provisions of

subparagraphs (h)(3)(d) and (h)(4)(a) and

through modifications to the definition

of non-cash compensation (Comment

10). The commenter stated that the de

minimis exception could be included as

new subparagraph (h)(5) and would

state in substance:

The provisions of subparagraph (ii) of

paragraphs (h)(3)(d) and (h)(4)(a) shall not

apply to the production of associated persons

with respect to variable contracts issued by

a non-affiliate of the member to the extent

that such variable contracts, in the aggregate,

account for [an insubstantial percentage] of

the total production of associated persons

with respect to variable contracts; and further

provided that the member does not actively

promote such variable contracts to its

associated persons nor permit the offeror of

such variable contracts to do so. However,

the member shall be required to provide such

weight to the production in variable contracts

issued by a non-affiliate as it determines, in

good faith, best reflects the relative

contribution of such production to the

profitability of the member, taking into

account the desirability of promoting, to the

maximum extent practicable, parity in

commissions between such product(s) and

comparable products, if any, issued by an

affiliate (Comment 10).

The commenter also recommended

that the definition of non-cash

compensation be revised to read as

follows: ‘‘Non-cash compensation’’ shall

mean any merchandise, gifts, prizes,

payment of travel expenses, meals and

lodging and all other similar items,

including cash payments in lieu of any

of the foregoing, received in connection

with the sale and distribution of

variable contracts.’’ The commenter

stated that, as so revised, the definition

would be sufficiently broad so as to

encompass those items of non-cash

compensation that have traditionally

been viewed as having the greatest

potential for abuse. By including the

phrase ‘‘including cash payments in lieu

of any of the foregoing,’’ the definition
Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices 47095

also would be sufficiently encompassing

so as to prevent the abuse that

subparagraph (h)(4) of the proposed

rules was seemingly designed to

address; namely that offerors might seek

to ‘‘monetize’’ non-cash incentives to

circumvent the provisions of the rule.

However, the definition would not be so

broad so as to unintentionally include

items, like health insurance benefits,

tuition reimbursement programs, etc.,

which traditionally have not been

viewed as point-of-sale incentives

(Comment 10).

One commenter strongly

recommended that the proposed rules

be amended by deleting Sections (h)(4)

and (1)(6) in their entirety (Comment

20).

Another commenter suggested that:

(1) the proposed incentive

compensation requirements as they

relate to proprietary/non-proprietary

products be eliminated or revised;

specifically, that the total production

and equal weighting requirements might

be applied separately to all proprietary

products together; and, in any case, (2)

an exemption be provided for

companies for whom the amount of

non-proprietary product sales is not

material, i.e., a test of materially, or for

whom the proprietary and nonproprietary products do not compete

(Comment 22).

One commenter stated that the

language relating to the inclusion of all

investment company securities in

incentive arrangements is over-broad

and unduly restrictive (Comment 16).

The commenter stated that an incentive

arrangement which includes both a

broad base of funds and funds of each

fund family sold by the broker-dealer to

an equal extent would meet the

objectives of the proposed rules and

recommended that the relevant language

of proposed Rules 2830(I)(5)(d)(i) and

2830(I)(6)(a)(i) be changed to read as

follows:

The member’s or non-member’s [non-cash

compensation] arrangement, if it includes

investment company securities, must (a)

include a broad range of investment company

securities, (b) not discriminate within the

range among investment companies included

in the arrangement and (c) give equal

weighting to the sale of all investment

company securities included in the

arrangement by the member (Comment 16).

The same commenter disagrees with

the manner in which the NASD

proposes to accomplish prospectus

disclosure of cash compensation. The

commenter states that full service firms

which neither act as underwriter for

mutual funds sold to its clients nor

control the issuer or underwriter of such

funds, and thus have very limited

ability, if any, to influence the contents

of prospectuses, bear the burden

adequate prospectus disclosure.

Moreover, the proposed rules would

place an extraordinary administrative

burden on such firms by requiring

continuous review of each funds

prospectus to evaluate whether the cash

compensation disclosure requirements

of the proposed rules have been

satisfied (Comment 16).

The commenter recommends,

therefore, that the proposed

amendments be modified to prohibit the

‘‘underwriter’’ from paying any cash

compensation that is not disclosed in

the fund prospectus, and would define

the term ‘‘underwriter’’ to include ‘‘any

person which, directly or indirectly

controls, in controlled by or is under

common control with the underwriter.’’

The commenter stated that this

recommended change should

accomplish the NASD’s purpose of

holding a person under its jurisdiction

responsible for prospectus disclosure. In

addition, because underwriters of

investment company securities are

generally under common control with

the issuer of the investment company

securities, it is much more likely that

they can control or influence the

disclosure contained in the fund’s

prospectus. Such an approach is

consistent with Federal securities laws,

which subjects underwriters to

‘‘prospectus liability,’’ but not brokerdealers acting as agent in the sale of

securities (Comment 16).

Specific Commission Requests for

Comments

The Commission Release contained

requests for comment on four specific

issues. The requests are restated below

with a summation of the commenters’

responses.

1. The proposed rule change would

continue to permit an associated person

to accept gifts if the total value does not

exceed $100 and an occasional meal, a

ticket to a sporting event or the theater,

or comparable entertainment. Should

members be required to keep records of

such gifts or entertainment to enable the

NASD to surveil effectively for abuse?

The unanimous response of those

commenters who answered this

question was that, since such de

minimis activity does not undermine a

broker-dealer’s supervisory control over

registered representatives or create the

appearance of impropriety, imposing

recordkeeping requirements concerning

these activities is not warranted

(Comments 2, 3, 4, 5, 7, 8, 12, 16, 20,

23, 26, 27, 28).

2. The proposed rule change would

permit a member or an associated

person to accept payment or

reimbursement from an offeror for

expenses incurred in connection with

meetings held by the offeror for the

purpose of training or educating

associated persons of a member. Are the

recordkeeping requirements proposed

by the NASD sufficient to support

determinations of whether such

meetings will be bona fide? Most

commenters who responded felt that

additional recordkeeping in this area

was not needed (Comments 2, 3, 4, 7,

26, 27, 28).

Other commenters stated that the

requirements were not sufficient

(Comments 5, 8, 14). One commenter

stated that such records should also

include the identification of the nearest

office of the member and should contain

information relating to the agenda of the

meeting in order to document the

determination of a bona fide meeting

(Comment 5). Another commenter

stated that the recordkeeping

requirement with respect to education

and training meetings should be

sufficient to indicate the substance of

the meeting and to demonstrate that the

location and related activities were

appropriate (Comment 8). The

commenter suggested that the following

information, in addition to that required

by the proposed rules, should be

sufficient for these purposes: a

description of the purpose of the

meeting, a statement of the basis on

which the member approved attendance

at the meeting by the associated person

(which would also evidence member

approval), and a copy of the agenda of

the education and training portion of

the meetings (Comment 8). Finally,

another commenter suggested that

proposed rules are inadequate because

they do not require records to be kept

with respect to the location of such

meetings (Comment 16).

3. The NASD states in its filing that

a member holding a training or

education meeting for its associated

persons would not be required to

comply with the conditions imposed

with respect to training and education

meetings held by offerors or unaffiliated

members ‘‘if the member does not

receive a payment or reimbursement

from an offeror for the expenses of the

meeting.’’ In any event, the member

would not be prohibited from permitting

offerors to make a presentation at the

meeting. Commenters are asked to

address whether a training and

education meeting should constitute

non-cash compensation subject to the

proposed rule change if an offeror

participates in organizing the meeting

even though an identical meeting would

not be subject to the proposed rule
47096 Federal Register / Vol. 62, No. 172 / Friday, September 5, 1997 / Notices

1The proposal was originally filed on July 29,

1997, but was subsequently amended on August 25,

1997.

change if organized by the member for

its own associated persons. Some

commenters who responded felt that

when a broker-dealer conducts training

and educational seminars with offeror

participation it should not constitute

non-cash compensation, because the

broker-dealer is fully aware of the

offeror’s participation, because the

broker-dealer’s supervisory control is

not diminished or undermined, because

this is not typically an area of abuse, or

because flexibility is needed to arrange

meetings at locations convenient to

attendees and within the budgets

available (Comments 2, 7, 20, 23, 26, 27,

28).

Other commenters stated that mere

offeror participation, as long as the

offeror does not provide any monetary

contributions, should not result in the

meeting being treated as non-cash

compensation (Comments 3, 4, 5, 8).

4. The Tully Committee identified the

practice of payment of higher

commission to registered representatives

for proprietary products than for nonproprietary products as an arrangement

that can create conflicts of interest. The

proposed rule change would not

prohibit or regulate this practice. The

proposed rule change would, however,

prohibit a contest granting cash awards

if the contest gives greater weight to

certain securities than others.

Commenters are invited to address

whether the proposed rule change

should be extended to cover ordinary

compensation practices in addition to

incentive compensation practices. Most

commenters who responded stated that

the proposed rule change should not

cover ordinary compensation practices

because the regulatory objectives cited

in the proposed amendments are

unrelated to the payment of

commissions, such an approach would

have anti-competitive implications,

such an approach would delay the date

of effectiveness of the proposed rules, or

it would result in duplicative,

overlapping regulation (Comments 2, 3,

6, 7, 8, 12, 13, 16, 23, 26, 27).

One commenter, however, stated that

he could see barring differentials in cash

compensation, since cash compensation

is the strongest possible incentive

(Comment 4). Another commenter

stated that The Tully Committee’s report

on compensation practices voiced

concern over possible conflicts of

interest created by both higher

commission payments for proprietary

products and narrowly focused

incentive sales contests. If such

practices genuinely create conflicts of

interest, the effect of the proposed rule

change is to allow higher commissions

to be paid year round under a general

period. We fail to see the distinction.

The ultimate issue for regulatory

consideration should be suitability.

Regulatory authorities should determine

whether or not a conflict of interest is

created by higher payments, regardless

of the duration of the program and

provide consistent proposals for rule

changes accordingly (Comment 5).

[FR Doc. 97–23540 Filed 9–4–97; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–38990; File No. SR–NASD–

97–56]

Self-Regulatory Organizations; Notice

of Filing of Proposed Rule Change by

National Association of Securities

Dealers, Inc. Relating to the Creation of

New Rules 6900 Through 6970 or an

Audit Trail System Owned and

Operated by the National Association

of Securities Dealers, Inc.

August 28, 1997.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’), 15 U.S.C. 78s(b)(1), notice is

hereby given that on August 25, 1997,1

the National Association of Securities

Dealers, Inc. (‘‘NASD’’) 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, Inc.

(‘‘NASDR’’). The Commission is

publishing this notice to solicit

comments on the proposed rule change

from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

NASD Regulation is proposing new

Rules 6900 through 6970 of the Conduct

Rules of the NASD, relating to an audit

trail system owned and operated by the

NASD that is designed to capture order

information reported by members for

integration with The Nasdaq Stock

Market, Inc. (‘‘Nasdaq’’) quote

information and trade information

reported to the Automated Confirmation

Transaction Service (‘‘ACT’’) in order to

provide the Association with an

accurate time sequenced record of

orders and transactions. Below is the

text of the proposed rule change.

Proposed new language is underlined.

3110. Books and Records

* * * * *

(c) Each member that acts as a market

maker in an equity security quoted in

the Nasdaq system shall record, with

respect to each order for such security

that is received and executed at its

trading department, an identification of

each registered person who executes the

order.

* * * * *

6900. Order Audit System

6910. Definitions

For purposes of the Rules 6900

through 6970:

(a) Terms shall have the same

meaning as those defined in the ByLaws and other rules of the Association,

unless otherwise specified.

(b) ‘‘Association’’ shall mean the

National Association of Securities

Dealers, Inc. and its two subsidiaries,

NASD Regulation, Inc. and The Nasdaq

Stock Market, Inc.

(c) ‘‘Customer’’ shall mean a person

other than a broker or dealer.

(d) ‘‘ACT’’ shall mean the Automated

Confirmation Transaction Service

operated by Nasdaq, Inc.

(e) ‘‘Index Arbitrage Trade’’ shall

mean an arbitrage trading strategy

involving the purchase or sale of a

‘‘basket’’ or group of securities in

conjunction with the purchase or sale,

or intended purchase or sale, of one or

more cash-settled options or futures

contracts on index stock groups, or

options on any such futures contracts in

an attempt to profit by the price

difference, as further defined in New

York Stock Exchange Rule 80A.

(f) ‘‘Order’’ shall mean any oral,

written, or electronic instruction to

effect a transaction in a Nasdaq equity

security that is received by a member

from another person for handling or

execution, or that is originated by a

department of a member for execution

by the same or another member, other

than any such instruction to effect a

proprietary transaction originated by a

trading desk in the ordinary course of a

member’s market making activities.

(g) ‘‘Order Audit System’’ shall mean

the automated system owned and

operated by the Association that is

designed to capture Order information

reported by members for integration

with trade information reported to ACT

and quotation information disseminated

by members in order to provide the

Association with an accurate time

sequenced record of orders and

transactions.

(h) ‘‘Program Trade’’ shall mean a

trading strategy involving the related

purchase or sale of a group of 15 or