Alert April 26, 2011

FINRA Proposes to Amend NASD Rule 2830 Regarding Investment Company Securities

On April 19, 2011, FINRA filed a rule proposal with the SEC to amend NASD Rule 2830 (Investment Company Securities) and to incorporate it into the FINRA rulebook as FINRA Rule 2341.  Rule 2830 applies to the activities of FINRA member firms in connection with the offering of securities of companies registered under the Investment Company Act of 1940.  Excluded from the rule are variable contracts of an insurance company, the sale of which is governed by FINRA Rule 2320.

Rule 2830, among other things, imposes limits on the amount and types of compensation member firms may receive for the sale of investment company shares.  Paragraph (l)(4) currently prohibits a member from receiving cash compensation from an offeror of investment company shares unless the compensation is described in a current prospectus of the investment company.  By interpretation of the FINRA staff (in Notice to Members 99‑55, Question #18), the information requirement may also be satisfied by disclosure in a fund’s statement of additional information (“SAI”).  When special cash compensation arrangements are made available by the offeror to a member, and those arrangements are not available on the same terms to all members that distribute the investment company’s shares, paragraph (1)(4) prohibits the member from entering into the arrangement unless details of the arrangement are disclosed in the prospectus.  Proposed Rule 2341 would amend paragraph (l)(4) by shifting the disclosure obligation from the issuer to the member entering into the arrangement.  Members receiving special cash compensation would be required to make two types of disclosure.  First, the member would be required to prominently disclose in paper or electronic form, prior to the time a customer first purchases shares of an investment company through the member, the following matters:

  • that the member has received, or has entered into an arrangement to receive, cash compensation from investment companies and their affiliates, in addition to sales charges and service fees disclosed in the prospectus fee table;
  • that this additional cash compensation may influence the selection of investment company shares that the member and its associated persons offer or recommend to investors; and
  • a reference (or in the case of electronically delivered documents, a hyperlink) to the web page or toll-free number of the member firm at which the second type of disclosure, described below, is provided.

For existing customers as of the effective date of the rule change, the disclosure above would have to be made by the later of 90 days after the effective date of the rule change or prior to the customer’s first purchase of investment company shares through the member.

A member would also be required to provide the following information, in a web page or through a toll-free telephone number, and update it at least annually:

  • A narrative description of the additional cash compensation received from offerors, or to be received pursuant to an arrangement entered into with an offeror, and any services provided or to be provided by the member to the offeror or its affiliates for the additional cash compensation;
  • If applicable, a narrative description of any preferred list of investment companies to be recommended to customers that the member has adopted as a result of the receipt of additional cash compensation, including the names of the investment companies on the list; and
  • The names of the offerors that have paid, or entered into an arrangement to pay, this additional cash compensation to the member.

The amended rule would add a definition of “cash compensation” that would include, among other things, payments under revenue sharing arrangements between the member firm and the investment company’s adviser in connection with the sale and distribution of the investment company shares.  The amended rule would also codify existing exemptions from the rule for exchange-traded funds (“ETFs”).

FINRA proposes to provide a delay of implementation of the rule for up to 365 days following SEC approval to allow member firms adequate time to prepare for compliance.  Comments on the rule proposal will be due within 45 days of publication in the Federal Register.