39614 Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices

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

2Securities Exchange Act Release No. 39872

(April 14, 1998), 63 FR 19991 (File Nos. SR–MCC–

98–01 and SR–MSTC–98–01).

3Securities Exchange Act Release No. 36684

(January 5, 1995), 61 FR 1195 [File Nos. SR–MCC–

95–04, SR–MSTC–95–10] (order approving

proposed rule changes relating to the withdrawal of

the Chicago Stock Exchange, Incorporated from the

clearance and settlement and securities depository

businesses, conducted principally through its

subsidiaries, MCC and MSTC).

4Securities Exchange Act Release No. 39759

(March 6, 1998), 63 FR 14153 (order approving a

proposed rule change relating to the structure and

composition of CHX’s board of governors).

Historically, the MCC’s and MSTC’s board of

directors have been the same as the CHX’s board

of governors. As a result of these changes, half of

MCC and MSTC’s boards will be ‘‘non-industry’’

directors as defined in CHX’s constitution.

5Class I will consist of seven directors, class II

will consist of seven directors, and class III will

consist of eight directors.

6 15 U.S.C. 78q–1(b)(3)(F).

7 17 CFR 200.30–3(a)(12).

1On 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. A

final amendment, Amendment No. 4, was filed on

December 2, 1997. 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 were

incorporated into and published in the Federal

Register notice of the proposed rule change. See

Securities Exchange Act Release No. 38993 (August

29, 1997), 62 FR 47080 (September 5, 1997).

Amendment No. 2 made technical changes to

Amendment No. 1. See letter from John Ramsay,

NASD Regulation to Katherine A. England,

Assistant Director, 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. These two technical

amendments do not need to be published for

comment. Amendment No. 4 was filed on December

2, 1997. See letter from John Ramsay, NASD

Regulation to Katherine A. England, Assistant

Director, Commission Amendment No. 4 responds

to comment letters received by the Commission in

response to its notice of the filing and solicitation

of comment. It is a technical amendment and

therefore not subject to notice and comment. NASD

Regulation’s response is discussed in detail in

Section III of this approval order.

2 15 U.S.C. 78s(b)(1).

3 17 CFR 240.19b–4.

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–40206; File Nos. SR–MCC–

98–01 and SR–MSTC–98–01]

Self-Regulatory Organizations; The

Midwest Clearing Corporation; the

Midwest Securities Trust Company;

Order Approving Proposed Rule

Changes Relating to the Structure and

Composition of the Board of Directors

July 15, 1998.

On February 9, 1998, the Midwest

Clearing Corporation (‘‘MCC’’) and the

Midwest Securities Trust Company

(MSTC) filed proposed rule changes

with the Securities and Exchange

Commission (‘‘Commission’’) pursuant

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

Exchange Act of 1934 (‘‘Act’’) 1 and on

February 25, 1998, amended the

proposed rule changes. Notice of the

proposals was published in the Federal

Register on April 22, 1998.2 For the

reasons discussed below, the

Commission is approving the proposed

rule changes.

I. Description

The proposed rule changes amend

MCC’s and MSTC’s by-laws in order to

reflect the cessation of their securities

clearing and depository services 3 and to

streamline the structure and

composition of their board of directors

in order to remain consistent with the

changes recently made by the Chicago

Stock Exchange, Incorporated (‘‘CHX’’).4

The proposed rule changes reduce the

number of directors from 27 to 24 and

realign the classes for both MCC and

MSTC. The directors are still divided

into three classes, but the size and

composition will be adjusted as follows.

At the 1998 annual election, class I will

be reduced by two directors. At the 1999

annual election, class II will be reduced

by four directors. At the 2000 annual

election, class III will be reduced by one

director, and class II will be increased

by one director. The board of directors

will also be increased by three

additional ‘‘non-industry’’ directors by

the 1999 annual election to serve for

staggered terms so as to balance the

classes as determined by the nominating

committee.5

II. Discussion

Section 17A(b)(3)(F) 6 of the Act

requires that the rules of a clearing

agency be designed to protect investors

and the public interest. The

Commission believes that the change in

the composition of MCC’s and MSTC’s

board of directors should help MCC and

MSTC to better protect investors and the

public interest. As a result of the

modifications to the boards, there will

be fifty percent representation of nonindustry directors on MCC’s and

MSTC’s board of directors. If carefully

selected, non-industry directors should

bring diverse experience to the boards

and thus enable MCC and MSTC to

better perform their self-regulatory

obligations.

III. Conclusion

On the basis of the foregoing, the

Commission finds that the proposals are

consistent with the requirements of the

Act and in particular with the

requirements of Section 17A of the Act

and the rules and regulations

thereunder.

It is therefore ordered, pursuant to

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

proposed rule changes (File Nos. SR–

MCC–98–01 and SR–MSTC–98–01) be

and hereby are approved.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.7

Jonathan G. Katz,

Secretary.

[FR Doc. 98–19571 Filed 7–22–98; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–40214; File No. SR–NASD–

97–35]

Self-Regulatory Organizations; Order

Granting Approval of Proposed Rule

Change Filed 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

July 15, 1998.

I. Introduction and Background

On May 7, 1997,1 the National

Association of Securities Dealers, Inc.

(‘‘NASD’’) filed with the Securities and

Exchange Commission (‘‘Commission’’)

a proposed rule change pursuant to

Section 19(b)(1) of the Securities

Exchange Act of 1934 (‘‘Act’’) 2 and Rule

19b–4 thereunder 3 to amend NASD

Conduct Rules relating to the regulation

of non-cash compensation in connection

with the sale of investment company

securities and variable contracts.

Over the past years, the SEC, the

investing public and the securities

industry have raised concerns about

actual and potential conflicts of interest

in the retail brokerage business.

Responding to these concerns, in May
Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices 39615

4See Report of the Tully Committee on

Compensation Practices, April 10, 1995.

5See e.g., order approving proposed rule change

relating to the offering on non-cash sales incentives

as inducement to sell interests in direct

participation programs. Securities Exchange Act

Release No. 26185 (October 14, 1988), 53 FR 41262

(October 20, 1998). See also order approving

proposed rule change to prohibit NASD members

and associated persons from accepting non-cash

compensation in connection with the sale of real

estate investment trust, and debt or equity corporate

offerings. Securities Exchange Act Release No.

26186 (October 14, 1988), 53 FR 41265 (October 20,

1988).

6See Securities Exchange Act Release No. 37374

(June 26, 1996), 61 FR 35822 (July 8, 1996).

7See Securities Exchange Act Release No. 37374

(June 26, 1996), 61 FR 35822 (July 8, 1996).

Notwithstanding its decision to bifurcate the

regulation of cash and non-cash compensation in

the instant filing, NASD Regulation has informed

the Commission that it 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 Regulation staff continues to

believe 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 interest of

customers.

As a result of its continuing concerns regarding

the appropriate regulatory response to cash

compensation arrangements, in August 1997, NASD

Regulation issued Notice to Members 97–50, which

solicited comments pertaining to conflicts of

interest arising from the payment of cash

incentives. Among other things, Notice to Members

97–50 solicited comment as to whether cash

compensation should be subject to disclosure

versus substantive prohibitions.

1994, an industry committee chaired by

Merrill Lynch Chairman Daniel P. Tully

(‘‘Tully Committee’’) was formed at the

request of SEC Chairman Levitt to

address concerns regarding conflicts of

interest in the brokerage industry. The

Tully Committee reviewed industry

compensation in connection with the

sale of all forms of securities for

associated persons of members,

identified conflicts of interest inherent

in such practices, and identified ‘‘best

practices’’ used in the industry to

eliminate or reduce such conflicts of

interest. A report was subsequently

issued by the Tully Committee in April

1995 (the ‘‘Tully Report’’).4 NASD

Regulation, a wholly owned subsidiary

of the NASD, believes this proposed

rule change is consistent with the

characteristics of ‘‘best practices’’

identified in the Tully Report to the

extent that the proposal helps to better

align the interests of associated persons,

broker-dealers and investors with

respect to investment company

securities and variable contracts.

The proposal 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 changes

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.5 in December

1995, the NASD filed with the

Commission proposed rule change SR–

NASD–95–61, which proposed

substantive prohibitions regarding noncash compensation and incentive-based

cash compensation, in connection with

investment company and variable

contract sales. SR–NASD–95–61 was

published by the Commission for

comment on July 8, 1996,6 SR–NASD–

95–61 raised significant issues among

comments regarding the nature and

treatment of certain incentive-based

cash compensation arrangements, in

particular those cash compensation

arrangements of insurance-affiliated

member firms. Most of the commenters

opposed the proposed provisions to

regulate incentive-based cash

compensation, stating among other

things, that the provisions pertaining to

cash compensation were over-broad in

their scope. In response to the

commenters, NASD Regulation chose to

delete those provisions proposing to

impose substantive prohibitions

regarding incentive-based cash

compensation. The NASD therefore

withdrew SR–NASD–95–61 and

replaced it with the filing approved

herein, SR–NASD–95–35, which does

not contain provisions imposing

substantive regulations on the receipt of

cash compensation arrangements.7

II. Summary Description of the

Proposed Rule Change

In general, the terms of the rule

change would 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. Limited

exceptions to this general prohibition

allow an associated person to receive

payment from persons other than his or

her NASD member firm where the

compensation is approved by the

member, or compensation received by

the associated person is treated as

compensation received by the member

for purposes of NASD rules.

New record keeping provisions of the

proposed rule change would require

that members maintain records of any

compensation, cash or non-cash,

received by the member or its associated

person from offerors. NASD Investment

Company Rule 2830, as amended,

would prohibit receipt by a member of

cash compensation from the offeror

unless such arrangement is described in

the current prospectus. NASD

Investment Company Rule 2830

prohibitions against a member receiving

compensation in the form of securities

would be retained. The amendments

would prohibit, moreover, 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 prohibitions 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 of

reimbursement for training and

educational meetings held by a brokerdealer or 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 fund 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.

The proposed rule amendments

would define the terms ‘‘affiliated

member,’’ ‘‘compensation,’’ ‘‘cash

compensation,’’ ‘‘non-cash

compensation,’’ and ‘‘offeror.’’ NASD

Regulation is proposing to adopt a

definition of the term ‘‘affiliated

member’’ for both the Investment

Company Rule, Rule 2830, and the

Variable Contract Rule, Rule 2820, to

include a member that, directly or

indirectly, controls, is controlled by, or

is under common control with a nonmember company. The term is used in

the sections of the proposed rule change

which address incentive compensation

arrangements in order to identify a

common type of relationship existing in

the investment company and variable

contracts industries, whereby a nonmember owns or controls one or more

subsidiary broker-dealer member firms

for underwriting and/or wholesale and

retail distribution services.

For ease of reference in appropriate

paragraphs of the proposed rules, NASD

Regulation 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
39616 Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices

8 15 U.S.C. 80a-2(a)(3).

9 15 U.S.C. 80a-2(a)(40).

10See letters to Jonathan Katz, Secretary, SEC

from Banc One Corporation (‘‘Banc One’’), dated

September 29, 1997; Investment Company Institute

(‘‘ICI’’), dated September 26, 1997; M Financial

Group (‘‘M Financial’’), dated September 30, 1997;

Drinker Biddle & Reath (‘‘Drinker Biddle’’), dated,

September 29, 1997; Merrill Lynch Pierce, Fenner

& Smith Incorporated (‘‘Merrill Lynch’’), dated

October 1, 1997; Bruce Avedon, dated October 16,

1997; First Investors Corporation (‘‘First Investors’’),

dated October 16, 1997; and the Securities Industry

Association (‘‘SIA’’), dated October 16, 1997.

11See Letter from John Ramsay, Deputy General

Counsel, NASD Regulation Inc., to Katherine

England, Assistant Director, Division of Market

Regulation, SEC, dated December 2, 1998.

appropriate paragraphs in the proposed

rule language accordingly.

‘‘Cash compensation,’’ as proposed to

be defined in the Investment Company

and Variable Contract Rules, 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 assetbased 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.

The ‘‘non-cash compensation’’

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 ‘‘noncash compensation’’ encompasses

reimbursement for costs incurred by a

member or person associated with a

member in connection with travel,

meals and lodging.

Finally, NASD Regulation 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.

The term ‘‘offeror,’’ as defined in the

Variable Contracts Rule, would 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. 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. The term ‘‘affiliated

person’’ in the proposed definition of

‘‘offeror’’ is defined in accordance with

Section 2(a)(3) of the 1940 Act.8 The

term ‘‘underwriter’’ is defined in

Section 2(a)(40) of the 1940 Act.9 It is

intended to reference the principal

underwriter through which the

investment and insurance company

distributes securities to participating

dealers for sale to the investor.

III. Amendment No. 4 and NASD

Regulation’s Response to Comments

Received on the Proposal

The Commission received letters from

eight commenters regarding the

proposed rule change.10 Two of the

commenters generally supported the

proposal with modifications. Four of the

commenters opposed the proposal, and

two of the commenters requested

clarification regarding certain aspects of

the proposal, but did not assert an

opinion as to their general support of

opposition to the proposal. NASD

Regulation responded to the issues

raised by the commenters in a letter

dated December 2, 1998.11 This

response letter is discussed below in

addition to a description of the

amendments to the proposal that were

made as a result of comments received

from the Commission’s notice of the

proposal and solicitation of public

comment.

A. The Bifurcation of the Regulation of

Non-Cash and Cash Compensation

M Financial, Banc One, Merrill

Lynch, and the SIA expressed the

opinion that it would be imprudent and

potentially confusing to introduce

substantive regulations regarding noncash compensation prior to fully

evaluating the answers to the questions

regarding cash compensation raised by

NASD Regulation in Notice to Members

97–50. In responding to these

commenters, NASD Regulation notes

that since the late 1980s, the NASD,

with the support of its Investment

Company and Insurance Affiliated

Committees, has focused on crafting a

rule to address non-cash compensation

practices that create particularly strong

point-of-sale incentives and supervisory

problems for member firms. NASD

Regulation believes the proposed rule

change, which has the general support

of the industry, is appropriate to address

these issues and need not be linked to

cash compensation issues, which raise

much broader and more complicated

concerns.

The ICI urged NASD Regulation to

reinstate the cash incentive provision in

the earlier proposal SR–NASD–95–61 to

prevent cash payments directly to

individuals, because such payments

create the potential to undermine an

NASD member’s supervisory control

over its associated persons. In response,

NASD Regulation explains that the

intended purpose of the now deleted

cash incentive provision was to prevent

the monetizing of non-cash

compensation. NASD Regulation

determined to delete the cash incentive

provision in response to comments,

primarily from insurance affiliated

members, that the provision was overbroad, and to solicit comments in Notice

to Members 97–50 on cash

compensation issues. The potential of

payments to individuals to undermine

an NASD member’s supervisory control

over its associated person has always

been a major concern that the proposed

rule change has attempted to address.

Thus, paragraph (h)(1) and (l)(1) of the

proposed rule change, which were also

contained in predecessor versions, with

limited exceptions prohibit individual

associated persons from accepting any

compensation, cash or non-cash, from

anyone other than the member with

which the person is associated.

The ICI noted that in connection with

the discussion of the implementation

period of the proposed rule change,

NASD Regulation states that the

requirement that ‘‘[w]ith respect to the

non-cash and cash sales incentive

provisions, no new sales incentive

programs may be commenced after the

effective date’’ is incongruent with the

removal of the cash sales incentive

provision and needs to be clarified.

NASD Regulation agrees with this
Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices 39617

observation and has thus made a

technical amendment to the proposed

rule change to delete the words ‘‘and

cash’’ from the above cited statement.

B. Effective Date of Proposal

M Financial maintained that the

proposed implementation plan

interferes with the completion on

ongoing commitments, and NASD

Regulation should extend the ‘‘grace

period’’ for completing on-going

incentive programs. The proposal, M

Financial argues, does not allow

adequate time for insurers and brokerdealers to honor their commitments for

programs that have already begun.

Having taken this argument under

advisement, NASD Regulation believes

the proposed ‘‘grace period’’ is fair and

will not unduly burden the completion

of ongoing commitments, particularly

since industry participants have been

aware for some time of the proposed

rule and the proposed grace period and,

in many cases, have already begun to

adjust accordingly.

C. In-house Compensation Plans

Merrill Lynch and the ICI urged that

the proposed rule change be revised to

permit in-house incentive programs

where the compensation is based on

sales of investment company securities

within a designated broad investment

objective or category, rather than all

investment company securities sold by

the member. NASD Regulation is of the

opinion that it would be inappropriate

to permit in-house incentive programs

based on broad objectives or categories.

Some members, NASD Regulation notes,

may carry limited numbers of funds, or

only one fund, for a given objective or

category which, under the commenters’

suggestion could result in sales

incentive contests tied to one or a few

funds, which would vitiate the purpose

of the proposed rule.

D. Contributions of NASD Members to

Non-NASD Member Compensation

Arrangements

Drinker Biddle and the ICI maintained

that, although the proposed rule change

would permit a non-NASD member or

other NASD member to contribute to a

member’s permissible in-house noncash compensation arrangement, as

currently drafted, it could be read to

prohibit contributions by NASD

members to non-cash compensation

arrangements of non-NASD members,

for example, banks. The commenters

stated, moreover, that this is probably

an unintended consequence of a

revision to the prior proposal that not

only prohibits an NASD member or

person associated with a member from

accepting any non-cash compensation

(subject to certain specified exceptions),

but also prohibits members and

associated persons from making

payments or offers of payment of such

compensation. Thus, the commenters

recommended that the NASD clarify

that an NASD member also could

contribute to the non-cash

compensation arrangements of a nonNASD member, such as a bank,

provided that the arrangement complies

with the requirements of the proposed

rule change.

NASD Regulation agrees that

members should not be prohibited from

contributing to non-cash compensation

arrangements of a non-member,

provided that the arrangement complies

with the conditions of the proposed

rule. Thus, paragraph (h)(4)(E) of Rule

2820 is amended as follows: New

language has been underlined.

‘‘Contributions by a non-member

company or other member to a non-cash

compensation arrangement between a

member and its associated persons, or

contributions by a member to a noncash compensation arrangement of a

non-member, provided that the

arrangement meets the criteria in

subparagraph (h)(4)(D).’’

In addition, paragraph (1)(5)(E) of the

proposed Rule 2830 is amended as

follows:

‘‘Contributions by a non-member

company or other member to a non-cash

compensation arrangement between a

member and its associated persons, or

contributions by a member to a noncash compensation arrangement of a

non-member, provided that the

arrangement meets the criteria in

subparagraph (1)(5)(D).’’

E. Proposed Prospectus Disclosure

Three commenters objected to the

prospectus disclosure requirements

regarding certain compensation

arrangements. Specifically, Banc One

stated that the proposal to require

additional detailed disclosure in a

current prospectus regarding special

cash compensation arrangements,

including the names of individual

members engaged in such arrangements,

is unnecessary. Merrill Lynch and the

SIA noted that the current rule provides

that ‘‘[n]o underwriter or associated

person of an underwriter shall * * *

pay * * * any * * * concession * * *’’

which is not disclosed in the

prospectus, whereas the proposed rule

would be revised to state ‘‘[n]o member

shall accept any cash compensation

from an offeror unless such

compensation is described in a current

prospectus.’’ These commenters

expressed the opinion that the proposed

rule would inappropriately shift the

burden of ensuring that such disclosure

appears in the prospectus from

underwriters to NASD member dealers,

who are unable to write or control the

disclosure contained in an investment

company’s prospectus. The SIA

maintained, moreover, that the

disclosure requirement would be

inconsistent with the SEC’s proposal on

prospectus disclosure and confusing for

members, if the NASD mandated

additional disclosure at a time when the

SEC is trying to streamline prospectus

disclosure.

In responding to the comments

objecting to the proposed prospectus

disclosure, NASD Regulation notes that

the prospectus disclosure requirement

in the proposed rule change is similar

to the current prospectus disclosure

requirement, but the proposed rule

change applies only to cash

compensation. Rule 2830 currently

requires disclosure of all compensation,

including non-cash compensation, paid

or offered to be paid by an underwriter

or its associated person in connection

with the sale of investment company

securities. By contrast, the proposed

rule change governs the conduct of

NASD members who accept payments

in connection with investment company

securities. Specifically, the proposed

rule change prohibits NASD members

from accepting any cash compensation

from an offeror that is not described in

the current prospectus of the investment

company.

As to the concern that the proposed

rule change inappropriately shifts the

burden for disclosure from offerors of

funds to NASD member dealers, NASD

Regulation points out that the proposed

rule changes does not impose a specific

prospectus disclosure requirement on

the dealer-member; rather, the rule

prohibits the ‘‘acceptance’’ by a member

of cash and special cash compensation

unless disclosed in the prospectus.

Finally, NASD Regulation has stated in

the proposed rule change that it will

reevaluate prospectus disclosure in light

of the SEC’s recent initiatives for a

simplified prospectus.

F. Proposed Definitions

The SIA suggested modifications to

several of the proposal’s definitions.

Specifically, it maintained the

‘‘affiliated member’’ definition is too

narrow and should be modified to

include arrangements where member

firms and fund groups are affiliated

through ownership, but are not under

common control. NASD Regulation

believes expanding the definition of

affiliated member would expand the

universe of non-members that could
39618 Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices

12See Investment Company Act Release No.

23064 (March 13, 1998), 63 FR 13916 (March 23,

1998).

13 15 U.S.C. 78o–3.

sponsor a non-cash arrangement under

sub-paragraphs (h)4)(D) of rule 2820 and

(1)(5)(D) of Rule 2830 to non-members

that have only a business or investment

interest, rather than a control interest, in

a member. Subparagraphs (h)(4)(D) and

(1)(5)(D), as explained in Amendment

No. 4, were intended in part to give

member firms and their parent

insurance company or mutual fund

control over the sponsorship and

organization of a non-cash arrangement,

and to limit that control to such

relationships.

The SIA also suggested modifications

to the definition of service fee. It stated

that service fees are payments for

continuing investor services and, as

such, should be excluded from the

definition of ‘‘cash compensation.’’

NASD Regulation, in response, asserts

that it understands that ‘‘service fees’’

may serve myriad purposes and has

intentionally drafted a broad definition

of ‘‘cash compensation’’ to address the

various forms and ways in which such

compensation may be paid.

Noting that the definition of ‘‘offeror’’

would pick up any party that has a five

percent ownership arrangement with an

investment company, including an

investor owning more than five percent

of a fund, the SIA stated that the

definition is overly broad and the term

should be more narrowly defined. As

explained by NASD Regulation, the

definition of offeror was broadly drafted

to address those entities that may

function as offerors of cash or non-cash

compensation in connection with the

sale and distribution of investment

company and variable contract

securities. NASD Regulation believes

that it is very unlikely that an investor

could or would act in such capacity.

Finally, one commenter, Bruce

Avedon, requested that NASD

Regulation expressly clarify its position

that the definition of ‘‘cash

compensation,’’ as amended in Rule

2820, does not include fees and

reimbursement for reasonable travel

expenses paid to directors of life

insurance companies for attending

board of directors’ meetings. In response

to this request for clarification, NASD

Regulation notes that directors’ fees are

not paid pursuant to the sale and

distribution of securities, and it

therefore considers such fees to be

outside the purview of the new rule.

G. Training and Education Exceptions

The SIA requested specific

clarification that an issuer that is an

affiliate of a member firm could provide

compensation for training and

education programs under the

provisions of (l)(5)(C) of Rule 2830, as

well as under the provisions of (l)(5)(D).

Proposed paragraph (l)(5)(C), as

interpreted by NASD Regulation, would

permit an issuer that is an affiliate of a

member firm to provide payment or

reimbursement for a training and

education meeting held by the member,

as long as the five conditions under

(l)(5)(C) are satisfied. Proposed

paragraph (l)(5)(D), as interpreted by

NASD Regulation, does not address

training and education meetings.

Finally, the SIA requested

clarification that condition (v) of

provision (l)(5)(C), which specifies that

payment or reimbursement by an offeror

for a permissible training and education

program cannot be preconditioned by

the offeror on the achievement of a sales

target, does not preclude payment by an

offeror to a training or education

program aimed at the member’s top

producers during a given time period, or

payment by a fund to a training or

education program aimed at the

member’s top producers.

As explained in Amendment No. 4 to

the proposal, condition (ii) of

subparagraph (h)(4)(C) of Rule 2820 and

(l)(5)(C) of Rule 2830 states that

attendance by the member’s associated

persons at a training and education

meeting must, among other things, not

be preconditioned on the achievement

of a sales target. In connection with this

condition, NASD Regulation stated in

the proposed rule and reiterated in

response to comment letters, that the

condition is not, however, intended to

prevent a member from designating

persons to attend a meeting 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.

Consistent with this reasoning, as

explained by NASD Regulation,

condition (v) of Paragraph (l)(5)(C)

would not prevent payment of

reimbursement by an offeror for a

training or education program aimed at

the member’s top producers during a

given time period, or payment by a fund

to a training or education program

aimed at the member’s top producers, so

long as payment 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 preconditioned on achieving

a sales target.

IV. Conclusion

After carefully considering all

comments received and the NASD’s

response to comments, the Commission

has determined that the proposed rule

change should be approved. The

Commission believes that the

amendment is responsive to

commenters’ concerns. Indeed, in its

consideration of the views and opinions

expressed by commenters and the

NASD’s response, the Commission is of

the opinion that the NASD proposal, as

amended, complies with the

requirements of the statute. Although

further steps could be taken, and the

NASD is considering future action

regarding cash compensation

arrangements, the Commission believes

that the measured steps taken in the

proposal are consistent with the Act.

While some commenters urged that

NASD Regulation defer action on the

proposal until it addresses the issue of

cash compensation, the NASD has taken

considerable steps over the past decade

to address concerns raised by non-cash

compensation arrangements, and,

accordingly, the Commission believes it

is appropriate for the NASD to address

non-cash compensation arrangements at

this time, while continuing to consider

the most appropriate regulatory

approach to cash compensation

arrangements made in connection with

mutual fund and variable contract sales.

The Commission expects that future

proposals by NASD Regulation to

address the issue of cash compensation

will be consistent with the prospectus

disclosure principles that the

Commission set forth in amended Form

N–1A. These principles include a focus

on information central to investment

decisions and avoidance of detailed

highly technical disclosure that

discourages investors from reading the

prospectus or obscures essential

information about an investment in a

fund.12 In the release adopting

amendments to Form N–1A, the

commission noted its believe that if its

fund disclosure initiative are to have

their intended effect, all parties

involved in the disclosure process—

funds, their legal counsels and other

advisors, the Commission and its staff,

and other regulators and their staff—

should act consistently with the basic

disclosure principles that serve as the

cornerstone of the initiative.

The Commission believes the

proposed rule change is consistent with

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

the Act,13 which require in pertinent

part that the Association adopt and

amend its rules to promote just and
Federal Register / Vol. 63, No. 141 /Thursday, July 23, 1998 / Notices 39619

14 17 CFR 200.30–3(a)(12).

1 15 U.S.C. 78s(b)(1) (1994).

2 17 CFR 240.19b–4 (1997).

3The functions of the NAC include hearing

appeals and conducting reviews of disciplinary

proceedings, statutory disqualification proceedings,

and membership proceedings; reviewing offers of

settlement; reviewing exemptions granted or denied

by staff; and making recommendations to the Board

on policy and rule changes relating to securities

business and sales practices and enforcement

policies, including policies with respect to fines

and other sanctions. See Article V, Section 5.1 of

the NASD Regulation By-Laws.

4See Letter from T. Grant Callery, General

Counsel, NASD, to Katherine England, Assistant

Director, SEC, dated May 19, 1998. Several

additional non-substantive textual changes were

also provided by telephone call on June 2, 1998.

Telephone call between Alden Adkins, General

Counsel, NASD Regulation, and Mandy Cohen,

Attorney, SEC.

5Securities Exchange Act Release No. 40062

(June 3, 1998), 63 FR 32033.

6Article V, Section 5.2 of the NASD Regulation

By-Laws.

7 Id.

8Article VI of the NASD Regulation By-Laws.

9Article VII, Section 9 of the NASD By-Laws;

Article VI, Section 6.25 of the NASD Regulation ByLaws.

10 15 U.S.C. 78(b)(6).

equitable principles of trade, prevent

fraudulent and manipulative acts and

practices, and generally provide for the

protection of investors and the public

interest. Specifically, the proposed rule

change is designed to reduce point-ofsale impact of non-cash sales incentives

that may compromise the duty of

registered representatives to match the

investment needs of customers with the

most appropriate investment product.

The Commission believes the proposal

appropriately recognizes that the

interest of those giving investment

advice and those seeking investment

advice can diverge where non-cash

compensation exists as an incentive to

sell specific investment products.

Accordingly, the proposed rule

change is designed to limit

compensation arrangements that may

threaten the mutuality and harmony of

interest between firms, their

representatives, and the investing

public. To that end, the proposal

addresses direct and perceived conflicts

of interest stemming from non-cash

compensation arrangements, such as

contests offering lavish trips and

expensive prizes and gifts for the sale of

investment company and variable

contract securities. Investor confidence

in the operation of the securities

markets is in turn bolstered as a

consequence of the removal of such

conflicts of interest.

The proposal facilitates, moreover, the

ability of NASD members to execute

compliance and supervisory

responsibilities by restricting the

potential for third-party non-cash

incentives to undermine the supervisory

control of an NASD member with

respect to its associated persons. An

NASD member is thus assisted in its

efforts to create unbiased compensation

plans that are arranged with the

approval of, and administered and

recorded by, the member firm. The

Commission believes greater

supervisory and compliance control of

compensation structures of associated

persons will enhance the ability of

NASD members to implement policies

and procedures to ensure that registered

representative compensation structures

align the interests of the firm, the

registered representative, and the

investor.

It is therefore ordered, pursuant to

Section 19(b)(2) of the Act, that File No.

SR–NASD–97–35 be, and hereby is,

approved.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.14

Jonathan G. Katz,

Secretary.

[FR Doc. 98–19567 Filed 7–22–98; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–40213; File No. SR–NASD–

98–36]

Self-Regulatory Organizations;

National Association of Securities

Dealers, Inc.; Order Granting Approval

to Proposed Rule Change and

Amendment 1 Thereto Relating to AtLarge Industry Members of the

National Adjudicatory Council

July 15, 1998.

I. Introduction

On May 12, 1998, the National

Association of Securities Dealers, Inc.,

(‘‘NASD’’ or ‘‘Association’’) filed with

the Securities and Exchange

Commission (‘‘SEC’’ or ‘‘Commission’’)

a proposed rule change pursuant to

Section 19(b)(1) of the Securities

Exchange Act of 1934 (‘‘Act’’),1 and

Rule 19b–4 thereunder 2 to amend the

By-Laws of NASD Regulation, Inc.

(‘‘NASD Regulation’’) to permit one or

more Industry members of the National

Adjudicatory Council (‘‘NAC’’)3 to serve

as at-large Industry members of the

NAC. By letter dated May 19, 1998, the

Association filed Amendment 1 to the

proposed rule change.4 The proposed

rule change and Amendment 1 were

published for comment in the Federal

Register on June 11, 1998.5 No

comments were received. This order

approves the proposal.

II. Description of the Proposal

Currently, the NASD Regulation ByLaws authorize the NASD Regulation

Board to appoint a NAC of 12 to 14

members, and require that the number

of Non-Industry members equal or

exceed the number of Industry

members.6 Thus, the NAC generally will

consist of six or seven Industry

members, depending on the size of the

Board. The By-Laws also require that

beginning in 1999 and thereafter, all

Industry members represent a

geographic region.7 Industry members

must be nominated by a Regional

Nominating Committee and may be

challenged for the nomination.8 The

Regional Nominating Committees then

nominate their candidates to the

National Nominating Committee, which

makes the final determination as to the

nominees who are presented to the

NASD Regulation Board for

appointment to the NAC.9

The proposed rule change would

permit the Board to designate up to two

NAC Industry members who would not

be subject to the regional nominating

process; instead, these members would

be designated as at-large Industry

members of the NAC. The number of atlarge Industry members could vary from

year-to-year depending on the total

number of Industry seats on the NAC

and the number of regions selected by

the Board. For example, if the Board

determined that there should be a 12- or

13-member NAC (which would include

six Industry seats) and five regions, then

the Board could designate one at-large

Industry member. If the Board

determined that there should be a 14-

member NAC (which would include

seven Industry seats) and five regions,

then there could be two at-large

Industry members. If the number of

Industry seats and the number of

regions were equal, then there would be

no at-large Industry seats that year.

Thus, given the limitation on the size of

the NAC and the number of Industry

seats, the proposed rule change would

allow zero, one, or two at-large Industry

members in any given year.

III. Discussion

The Commission finds that the

proposed rule change is consistent with

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

the Act,10 which provides, among other

things, that the rules of a national

securities association be designed to

prevent fradulent and manipulative acts

and practices, to promote just and

equitable principles of trade, and in