Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Change Amending the Requirements for the Use in Advertisements and Sales Literature of Investment Company Rankings

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38369; File No. SR-NASD-96-39]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc.; Order Approving Proposed Rule Change Amending the

Requirements for the Use in Advertisements and Sales Literature of

Investment Company Rankings

March 5, 1997.

I. Introduction

On October 17, 1996,\1\ the National Association of Securities

Dealers, Inc. (``NASD'' or ``Association'') submitted to the Securities

and Exchange Commission (``Commission''), pursuant to Section 19(b)(1)

of the Securities Exchange Act of 1934 (``Act'') \2\ and Rule 19b-4

thereunder,\3\ a proposed rule change to amend the requirements for the

use in advertisements and sales literature of investment company

rankings.

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\1\ On November 21, 1996, the NASD filed Amendment No. 1 with

the Commission. The amendment clarified that rankings based on yield

may be based on periods of less than one year. The amendment also

made technical amendments to the text of the rule. See Letter from

John Ramsay, Deputy General Counsel, NASD Regulation, Inc. to

Katherine A. England, Assistant Director, Division of Market

Regulation, Commission, dated November 20, 1996.

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

\3\ 17 CFR 240.19b-4.

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Notice of the proposed rule change as amended, together with the

substance of the proposal, was published for comment in Securities

Exchange Act Release No. 37987 (November 25, 1996), 61 FR 64185

(December 3, 1996) (``Notice''). Four comment letters were received on

the proposal. This order approves the proposed rule change.

II. Description

In 1994, the Commission approved what is now IM-2210-3 of the NASD

Conduct Rules, which provides guidelines for the use of rankings in

investment companies' advertisements and sales literature

(``Guidelines'').\4\ Among other things, the Guidelines require that

all rankings used in advertising and sales literature by member firms

to promote non-money market mutual fund performance include rankings

over one, and, if available, five and ten year periods. Prior to the

guidelines, there were no specific standards for the use of rankings.

Members generally had selected rankings for whatever time period

produced the most favorable rankings for an investment company.

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\4\ Securities Exchange Act Release No. 34354 (July 12, 1994),

59 FR 36461 (July 18, 1994).

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Since the approval of the Rankings Guidelines, the staff of NASD

Regulation, Inc. (``NASDR'') has considered whether to allow for

greater flexibility in the use of time periods other than those

prescribed by the Guidelines. The staff noted that some rankings, which

are based on adjusted total return to reflect criteria and

methodologies established and imposed by the ranking entities, use time

periods that do not meet the three specifically prescribed time periods

contained within the Guidelines.\5\ NASDR staff determined that the

Guidelines, as originally approved, should be revised consistent with

the original goal that would prevent selectivity of time periods. The

NASD filed a proposed rule change to IM-2210-3 \6\ of the NASD's

Conduct Rules to allow for the use in advertisements and sales

literature of investment company rankings that represent short, medium

and long term performance.

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\5\ For example, one ranking entity has developed a ranking

system that summarizes an investment company's risk/reward profile

for three, five, and ten year periods. This system provides a

composite ranking that seeks to measure how well an investment

company has balanced return and risk in the past.

\6\ NASD Manual, Conduct Rules, Interpretative Material of the

Rules of the Association (CCH), IM-2210-3.

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The rule change revises subparagraphs (2) (B) and (C) to paragraph

(d) of IM-2210-3. The rule change clarifies that the use of one, five

and ten year time periods is required if such time periods are

published by the ranking entity.\7\ If rankings for the required time

periods are not published by the ranking entity, the rule change

provides that rankings representing short, medium and long term

performance must be provided in place of rankings for the required time

periods.\8\

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\7\ The Guidelines define ``Ranking Entity'' as ``* * * any

entity that provides general information about investment companies

to the public, that is independent of the investment company and its

affiliates, and whose services are not procured by the investment

company or any of its affiliates to assign the investment company a

ranking.''

\8\ In its discussions of how the terms ``short,'' ``medium''

and ``long term'' might be interpreted, NASDR staff considered time

frames of 1-4 years, 5-9 years and 10 years or more, respectively,

as an acceptable interpretation.

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The rule change also replaces the phrase ``in the category'' in

subparagraphs (2) (B) and (C) with the phrase ``relating to the same

investment category,'' to clarify that when members provide rankings

for advertisements and sales literature, rankings for the prescribed

time periods must be for the same investment category or subcategory as

the total return ranking that is being accompanied by the prescribed

ranking.

III. Summary of Comments

The Commission received four comment letters, three of which

supported the proposed rule change, and one that did not, and a

response to the comment letters.\9\ The comment letter from Lipper

Analytical Services, Incorporated (``Lipper'') divides its criticisms

into several different areas. Lipper stresses the importance of having

one, five and ten year performance periods as a way to stop ranking

companies from ``cherry picking'' performance periods in order to

maximize attractiveness of the funds. Lipper believes that the fact

that some funds do not have one, five or ten year histories is

sometimes very important to investors and that lowering the

``barriers'' will not alert the investor to the potential of an

unseasoned mutual fund.

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\9\ See letters to Jonathan G. Katz, Secretary, SEC, from Banc

One Corporation, Investment Company Institute, and Morningstar,

Incorporated, dated December 24, 1996, December 24,1996, and

December 20, 1996 respectively; letter to Margaret H. McFarland,

Deputy Secretary, SEC, from Lipper Analytical Services,

Incorporated, dated December 23, 1996; and letter to Katherine A.

England, Assistant Director, Market Regulation, SEC, from John

Ramsay, Deputy General Counsel, NASDR, dated January 23, 1997

(``NASDR letter'').

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Lipper next addresses the validity of the categories of funds that

are ranked. Lipper says that funds with similar investment

characteristics should be compared to each other but that comparing

dissimilar funds could be misleading. In addition, Lipper argues that

the one year measure is important to investors who may want to know the

short term performance of a fund and to different mutual fund

participants who may have different time requirements. Lipper adds that

all performance based advertising, including returns, rankings and

ratings, should be on the same basis. Lipper also argues against the

use of a single number that represents risk for an investment company,

saying that investors do not believe there can be a useful single

measure of risk. Any measure that involves the use of the word ``risk''

should have an explanation of the calculation procedures. Lipper says

that any measure that compares funds with securities indices and other

indices risks comparing unlike entities. Last, Lipper agrees that there

should be some improvement in the disclosure of fund advertising to

investors, and suggests that performance of funds should be measured in

rising and falling market conditions.

The comment letter from the Investment Company Institute (``ICI''),

[[Page 11511]]

although in support of the proposed rule change, has two comments on

the content of the filing. The ICI states that is does not believe that

the NASDR's suggestions of 1-4 years, 5-9 years and 10 years or more

\10\ are intended as definitions of short, medium and long, but rather

as an interpretation by the NASDR staff of the relative lengths of time

for each period. In addition, ICI states that the rule change does not

explicitly address whether a NASD member could use a short or medium

term ranking for a fund that has been in existence for at least one or

at least five years and for which rankings for the specified time

periods are not published by the ranking entity, but it supports that

result.

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\10\ The Commission notes that the correct time period suggested

by the NASD was 5-9 years for he medium time period and that a

mistake was made in the Notice, which reads ``5-5 years.''

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IV. Discussion

The Commission finds that the proposed rule change is consistent

with Section 15A(b) of the Act and the rules and regulations

thereunder, and, in particular, with the requirements of Section

15A(b)(6)\11\ that the rules of an association be designed to promote

just and equitable principles of trade, to prevent fraudulent and

manipulative acts, and, in general, to protect investors and the

public. The rule change provides a flexible framework within which

ranking entities using different methodologies can provide useful

information to investors in a way that is not harmful or misleading and

that still prevents selectivity of time periods. The Commission

believes that performance-adjusted rankings which use different time

periods than those prescribed by the Guidelines can help investment

company investors make informed investment decisions if presented in a

way that is not misleading.

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\11\ 15 U.S.C. 78o-3

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The Commission believes that a concern about selectivity of time

periods is adequately addressed by the rule change. The Commission

notes that under the proposed rule change, short, medium and long-term

rankings can only be used if one, five and ten year rankings are not

available. The Commission also notes that short, medium and long term

rankings are still uniform in nature and do not allow Ranking Entities

to randomly choose any time periods they want.

Lipper raises a valid concern about only comparing similar funds,

but the Commission believes that concern is addressed by the proposed

rule change. The rule change clarifies language in the rule by stating

that rankings for prescribed time periods must be ``* * * by the same

Ranking Entity, relating to the same investment category, and based on

the same time period.'' The NASD, further clarifying the ``relating to

the same investment category'' language, stated that rankings for the

prescribed time period must be for the same investment category or

subcategory as the total return ranking that is being accompanied by

the prescribed ranking.\12\

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\12\ See Notice and NASDR letter.

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The Commission notes Lipper's concern that a one year performance

ranking is important to investors who want to know the short-term

performance of a fund. The Commission believes that this concern is

adequately addressed by the requirement that one, five and ten year

time periods must be used if they are published by the ranking

entity.\13\ The Commission also believes that Lipper's concern that

different mutual fund participants have different time requirements is

addressed by the proposed rule change in that it now permits the use of

time periods other than one, five and ten years in certain

instances.\14\

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\13\ See NASDR letter.

\14\ The Commission believes that the concern about risk-based

rankings is not relevant to this proposed rule change because this

filing does not deal with the method of calculating the performance-

based rankings themselves, other than the length of time over which

the rankings must be calculated. The Commission also believes that

the suggestion that performance should be measured over rising and

falling market conditions is not relevant to this proposed rule

filing because this filing is concerned with the length of the time

period for measuring performance.

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The Commission also realizes that there may be instances where non-

disclosure of certain factors could cause the use of a ranking to be

misleading, notwithstanding that the ranking is in technical compliance

with the Ranking Guidelines.\15\ NASD recognized these concerns and

stressed that NASD rules governing communications with the public

require that all advertising and sales literature submitted for review

not be misleading,\16\ and that those rules give the NASDR broad

authority to prohibit the use of the misleading ranking.\17\

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\15\ For example, if a one-year ranking is used that coincides

with the tenure at the firm of a particular fund manager, the fact

that the fund manager has changed could be relevant. Similarly, if a

three-year ranking is used that encompasses a change in fund

managers at the firm, the fact that the ranking covers a period with

more than one fund manager could be relevant.

\16\ NASD Conduct Rule 2210(d)(1)(A) states that ``[a]ll member

communications with the public should provide a sound basis for

evaluating the facts in regard to any particular security * * *. No

material fact or qualification may be omitted if the omission * * *

would cause the advertising or sales literature to be misleading.''

NASD Conduct Rule 2210(d)(1)(B) further states that ``[e]xaggerated,

unwarranted or misleading statements or claims are prohibited in all

public communications of members.''

\17\ See Amendment #1, filed November 21, 1996 and NASDR letter.

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V. Conclusion

It is therefore ordered, pursuant to Section 19(b)(2) of the

Act,\18\ that the proposed rule change (SR-NASD-96-39) is approved.

\18\ 15 U.S.C. 78s(b)(2).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\19\

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\19\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-6197 Filed 3-11-97; 8:45 am]

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