Document ID: SEC-2006-0006-0001
Agency: sec
Document Type: Notice
Title: Self-regulatory organizations; proposed rule changes: National Association of Securities Dealers, Inc.
Posted Date: 2006-01-04T05:00Z

[Federal Register: January 4, 2006 (Volume 71, Number 2)]
[Notices]               
[Page 375-377]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr04ja06-97]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-53027; File No. SR-NASD-2005-117]

 
Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 
Thereto Seeking Permanent Approval of Rules Concerning Bond Mutual Fund 
Volatility Ratings Prior to Expiration of Pilot

December 27, 2005.

I. Introduction

    On September 28, 2005 and October 24, 2005 (Amendment No. 1),\1\ 
the National Association of Securities Dealers, Inc. (``NASD'') filed 
with the Securities and Exchange Commission (``SEC'' or 
``Commission''), pursuant to Section 19(b)(1) of the Securities

[[Page 376]]

Exchange Act of 1934 (``Act'') \2\ and Rule 19b-4 thereunder,\3\ a 
proposed rule change seeking permanent approval of NASD Rule 2210(c)(3) 
and Interpretive Material 2210-5 (collectively, the ``Rule'') 
concerning bond mutual fund volatility ratings prior to the expiration 
of the pilot on December 29, 2005. The Commission published the 
proposed rule change for comment in the Federal Register on November 7, 
2005.\4\ The Commission received one comment letter on the proposal.\5\ 
On December 16, 2005, NASD filed a response to the comment letter.\6\ 
This order approves the proposed rule change, as amended.
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    \1\ Amendment No. 1 clarified the date of expiration of the 
pilot program concerning bond mutual fund volatility ratings.
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
    \4\ See Securities Exchange Act Release No. 52709 (November 1, 
2005), 70 FR 67509 (November 7, 2005) (the ``Notice'').
    \5\ See letter from Amy B.R. Lancellotta, Senior Counsel, 
Investment Company Institute (``ICI'') to Jonathan G. Katz, 
Secretary, SEC, dated November 28, 2005 (the ``ICI Letter'').
    \6\ See letter from Joseph P. Savage, Associate Vice President, 
Investment Companies Regulation, NASD, to Katherine A. England, 
Assistant Director, Division of Market Regulation, SEC, dated 
December 16, 2005 (the ``NASD Response'').
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II. Description of the Proposed Rule Change

Background and Description of NASD's Rules on Bond Mutual Fund 
Volatility Ratings

    On February 29, 2000, the SEC approved on a pilot basis NASD 
Interpretive Material 2210-5, which permits members and their 
associated persons to include bond fund volatility ratings in 
supplemental sales literature (mutual fund sales material that is 
accompanied or preceded by a fund prospectus).\7\ At that time, the SEC 
also approved as a pilot NASD Rule 2210(c)(3), which sets forth the 
filing requirements and review procedures applicable to sales 
literature containing bond mutual fund volatility ratings. Previously, 
NASD staff interpreted NASD rules to prohibit the use of bond fund 
volatility ratings in sales material.
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    \7\ See Securities Exchange Act Release No. 42476 (February 29, 
2000); 65 FR 12305 (March 8, 2000) (SR-NASD-97-89).
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    IM-2210-5 permits the use of bond fund volatility ratings only in 
supplemental sales literature and only if certain conditions are met:
     The word ``risk'' may not be used to describe the rating.
     The rating must be the most recent available and be 
current to the most recent calendar quarter ended prior to use.
     The rating must be based exclusively on objective, 
quantifiable factors.
     The entity issuing the rating must provide to investors 
through a toll-free telephone number or web site (or both) a detailed 
disclosure on its rating methodology.
     A disclosure statement containing all of the information 
required by the Rule must accompany the rating. The statement must 
include such information as the name of the entity issuing the rating, 
the most current rating and the date it was issued, and a description 
of the rating in narrative form containing certain specified 
disclosures.
    Rule 2210(c)(3) requires members to file for approval with NASD's 
Advertising Regulation Department (``Department''), at least 10 days 
prior to use, bond mutual fund sales literature that includes or 
incorporates volatility ratings. If the Department requests changes to 
the material, the material must be withheld from publication or 
circulation until the requested changes have been made or the material 
has been re-filed and approved.
    IM-2210-5 and Rule 2210(c)(3) initially were approved on an 18-
month pilot basis that was scheduled to expire on August 31, 2001.\8\ 
NASD subsequently renewed the pilot several times, most recently with a 
proposed rule change that was effective upon filing and extended the 
pilot provisions until December 29, 2005.\9\
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    \8\ Id.
    \9\ See Securities Exchange Act Release No. 52372 (Aug. 31, 
2005); 70 FR 53405 (Sept. 8, 2005) (SR-NASD-2005-104); Securities 
Exchange Act Release No. 48353 (Aug. 15, 2003); 68 FR 50568 (Aug. 
21, 2003) (SR-NASD-2003-126); NASD Notice to Members 03-48 (Aug. 
2003); Securities Exchange Act Release No. 44737 (August 22, 2001); 
66 FR 45350 (August 28, 2001) (SR-NASD-2001-49); NASD Notice to 
Members 01-58 (Sept. 2001).
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Proposed Rule Change to Make Permanent IM-2110-5 and Rule 2210(c)(3)

    As indicated in the SEC's original order approving IM-2210-5 and 
Rule 2210(c)(3) on a pilot basis and the NASD Notice to Members 
announcing such approval,\10\ NASD requested the 18-month pilot period 
to consider whether:
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    \10\ See Securities Exchange Act Release No. 42476 (February 29, 
2000); 65 FR 12305 (March 8, 2000) (SR-NASD-97-89); NASD Notice to 
Members 00-23 (April 2000).
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     The Rule has facilitated the dissemination of useful, 
understandable information to investors;
     The Rule has prevented the dissemination of inappropriate 
or misleading information by members and associated persons;
     Additional guidance concerning the use of certain 
terminology may be necessary;
     The Rule should apply to in-house ratings;
     The Rule should apply to all investment companies; and
     Additional standards or guidance is needed to prevent 
investor confusion or minimize excessive variability among ratings of 
similar portfolios.
    Due to the small number of bond volatility ratings filings received 
during the Rule's initial 18-month pilot, NASD extended the pilot to 
accumulate more data with which to evaluate the program. Ultimately, 
during the entire period from February 2000, when the Rule was first 
approved, until September 2005 (when NASD initially filed this proposed 
rule change with the Commission), NASD received a total of 47 
submissions from seven NASD members. In general, the filings of sales 
material that contained bond fund volatility ratings have met the 
Rule's requirements.
    Based on its findings during this period, NASD has concluded that 
the Rule's provisions are appropriate and do not require further 
amendment before being made permanent. In particular, NASD believes 
that the Rule has facilitated the dissemination of useful and 
understandable information to investors and has prevented the 
dissemination of inappropriate or misleading information. In this 
regard, virtually all of the filings NASD has received under the Rule 
have met the Rule's requirements, and NASD is not aware of any investor 
complaints concerning sales material that contains volatility ratings. 
The level of member compliance with the Rule also suggests that members 
do not require additional guidance concerning the use of certain 
terminology in the Rule. Similarly, NASD is not aware of any concerns 
that investors may be confused or that there may be excessive 
variability among ratings or similar portfolios.
    NASD also has examined the issue of whether the Rule should apply 
to in-house ratings. At the time the Rule was approved, NASD observed 
that the Rule should not apply to in-house ratings on the grounds that 
they are not procured for a fee, are used primarily by fund investors 
as an aid in distinguishing between risk levels within a family of 
funds, and may be calculated using different methods from those used in 
calculating volatility ratings.\11\ NASD continues to believe that 
those are persuasive reasons to not apply the Rule to in-house ratings. 
NASD believes that in-house ratings do not raise the same

[[Page 377]]

concerns as third-party ratings, and thus do not merit application of 
the bond fund volatility ratings rule.
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    \11\ See Securities Exchange Act Release No. 42476 (February 29, 
2000); 65 FR 12305 (March 8, 2000) (SR-NASD-97-89).
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    NASD also believes that it is unnecessary at this time to apply the 
Rule to other types of investment companies, such as unit investment 
trusts. At no time throughout the extended pilot period has a member 
requested that the Rule apply to such material, and NASD is not aware 
of third-party volatility ratings that are being used to assess other 
types of investment companies. Accordingly, NASD sees no need to expand 
the Rule's scope in this manner.
    NASD believes that the Rule strikes an appropriate balance between 
the desire of some funds to advertise volatility ratings and the need 
to include appropriate disclosures related to those ratings in sales 
material. Accordingly, NASD believes that the Commission should approve 
the Rule, as is, on a permanent basis.
    IM-2210-5(b)(2) requires supplemental sales literature that 
includes bond fund volatility ratings to present the most recently 
available rating that ``reflects information that, at a minimum, is 
current to the most recently completed calendar quarter ended prior to 
use.'' At the time IM-2210-5 was adopted, this standard mirrored the 
timeliness standard for mutual fund performance advertising under Rule 
482 under the Securities Act of 1933. However, in 2003, the SEC amended 
Rule 482 to require mutual fund performance advertising to show 
performance that is current to the most recent calendar quarter ended 
prior to submission of an advertisement for publication, and to 
indicate where the reader may obtain performance that is current to the 
most recent month ended seven business days prior to use through a 
toll-free (or collect) telephone number or web site, or to present 
performance that meets this most recent month-end standard.\12\
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    \12\ Rule 482(g) under the Securities Act of 1933.
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    NASD understands that rating agencies typically monitor bond funds 
on a monthly basis, but that it is quite rare for such agencies to 
revise a volatility rating on a month-to-month basis. Accordingly, NASD 
does not believe that it is necessary to require that volatility 
ratings be current as of the most recent month end given that, among 
other things, unlike fund performance, such ratings do not frequently 
change once they are issued.

III. Summary of Comments Received and NASD Response

    The Commission received one comment letter from ICI on the proposal 
and a response to the comment letter by NASD.
    The ICI Letter generally expressed reservations about the use of 
bond mutual fund volatility ratings in supplemental sales 
literature.\13\ The ICI Letter also suggested that if the pilot program 
was approved on a permanent basis that: (i) All of the critical 
investor protections of the original pilot program should remain 
intact, (ii) the use of a single symbol, number or letter to describe a 
volatility rating should be prohibited and (iii) the timeliness 
requirements of IM-2210-5(b)(2) should be modified to mirror the 
requirements of Rule 482 under the Securities Act of 1933.\14\
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    \13\ ICI Letter, supra note 5, at 1.
    \14\ Id. at 1-2.
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    In response to ICI's general reservations regarding the use of bond 
mutual fund volatility ratings the NASD Response stated that ``during 
the five and one-half years that the [bond mutual fund volatility 
rules] have been in effect, NASD has found no evidence that the use of 
volatility ratings in fund sales literature has harmed investors.'' 
\15\ NASD also noted that it ``has not proposed to eliminate any of the 
disclosure, filing or other investor protection requirements that were 
contained in the original pilot rule.'' \16\
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    \15\ NASD Response, supra note 6, at 2.
    \16\ Id.
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    In addition, NASD expressed doubt that use of a single symbol, 
number or letter to describe volatility ratings harms investors, 
stating ``NASD fails to see how allowing the use of symbols, numbers 
and letters to describe a fund's volatility rating is any more harmful 
to investors than allowing symbols, numbers and letters to describe a 
fund's performance or performance ranking.'' \17\
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    \17\ Id. at 3.
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    Furthermore, NASD disagreed with ICI's recommendation to modify the 
timeliness requirements of IM-2210-5(b)(2).\18\ NASD indicated that 
``it is quite rare for [fund rating] agencies to revise a volatility 
rating on a month-to-month basis.'' Accordingly, NASD expressed its 
belief that it is not necessary ``to require that volatility ratings be 
current as of the most recent month end given that such ratings rarely 
change once they are issued.'' \19\ NASD, however, cautioned its 
members that a ``member may not distribute supplemental sales 
literature containing a bond fund volatility rating if the member knows 
or has reason to know that the rating is false or misleading, even if 
the rating was current as of the most recent calendar quarter end.'' 
\20\
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    \18\ Id.
    \19\ Id.
    \20\ Id. See also NASD Rule 2210(d)(1)(B).
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IV. Discussion and Findings

    After careful review, the Commission finds that the proposed rule 
change is consistent with the provisions of Section 15A(b)(6) of the 
Act, which requires, among other things, NASD rules be designed to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade, and, in general, to protect 
investors and the public interest. The Commission believes that making 
IM-2210-5 and Rule 2210(c)(3) effective on a permanent basis will 
protect investors and the public interest by permitting NASD members to 
provide investors with useful information in a manner designed to 
prevent dissemination of inappropriate or misleading information.

V. Conclusions

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change, as amended (SR-NASD-2005-117), 
be, and it hereby is, approved.
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    \21\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\22\
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    \22\ 17 CFR 200.30-3(a)(12).
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Nancy M. Morris,
Secretary.
[FR Doc. E5-8228 Filed 1-3-06; 8:45 am]

BILLING CODE 8010-01-P