[Federal Register: October 7, 2004 (Volume 69, Number 194)]
[Notices]
[Page 60200-60206]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr07oc04-80]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-50463; File No. SR-NASD-2003-13]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Approval of Proposed Rule Change and
Amendment No. 1 Thereto, and Notice of Filing and Order Granting
Accelerated Approval of Amendment Nos. 2 and 3 to Adopt New
Interpretive Material to NASD Rule 2210(d)(2)(N) to Allow NASD Member
Firms to Use Certain Investment Analysis Tools
September 28, 2004.
I. Introduction
On February 3, 2003, the National Association of Securities
Dealers, Inc. (``NASD'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC''), pursuant to section 19(b)(1) of
the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4
thereunder,\2\ a proposed rule change to adopt a new Interpretive
Material (``IM'') to NASD Rule 2210(d)(2)(N) that would allow NASD
member firms to use investment analysis tools that show the probability
that investing in specific securities or mutual funds may produce a
desired result. On February 27, 2003, the NASD amended the proposed
rule change.\3\ The proposed rule change, as amended, was published for
notice and comment in the Federal Register on April 3, 2003.\4\ The
Commission received seven comment letters on the proposal.\5\ On
December 2, 2003, the NASD responded to the comment letters and amended
the proposed rule change.\6\ The NASD filed another amendment to make
minor changes to the proposed rule change on February 27, 2004.\7\ This
order approves the proposed rule change as modified by Amendment No. 1.
Simultaneously, the Commission provides notice of filing of Amendment
Nos. 2 and 3 and grants accelerated approval of Amendment Nos. 2 and 3.
The complete text of the proposed rule change, as approved, is attached
as Exhibit A.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See February 27, 2003, letter from Barbara Z. Sweeney,
Senior Vice President and Corporate Secretary, to Katherine A.
England, Assistant Director, Division of Market Regulation, SEC, and
attachments (``Amendment No. 1''). The original proposed rule change
was inadvertently filed without page 5. In Amendment No. 1, NASD
removed pages 1-25 of the original filing and replaced them with new
pages 1-25. The Commission did not require the NASD to re-file pages
26-230.
\4\ See Securities Exchange Act Release No. 47590 (March 28,
2003), 68 FR 16325.
\5\ See infra note 8 (citing comment letters).
\6\ See December 2, 2003, letter from James S. Wrona, Associate
General Counsel, NASD, to Katherine A. England, and attachments
(``NASD Response Letter'' or ``Amendment No. 2''). See also infra
Section III (discussing the NASD's response to comments and
amendments to the proposed IM).
\7\ See February 26, 2004, letter from James S. Wrona to
Katherine A. England, and attachments (``Amendment No. 3''). In
Amendment No. 3, the NASD made changes to the format of the proposed
rule language, and added specific references to NASD and Commission
rules and requirements.
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II. Summary of Comments
The Commission received seven comment letters on the NASD's
proposed rule change as modified by Amendment No. 1.\8\ One comment
letter supported the NASD's rule change as originally proposed, five
supported the proposed rule change but suggested certain modifications,
and one opposed the proposed rule change.\9\ The following summary of
comments provides an overview of the commenters' concerns:
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\8\ See the following letters to Jonathan G. Katz, Secretary,
SEC: April 24, 2003, letter from Alexander C. Gavis, Associate
General Counsel, Fidelity Investments (``Fidelity Letter''); April
24, 2003, letter from Tamara K. Salmon, Senior Associate Counsel,
Investment Company Institute (``ICI Letter''); April 24, 2003,
letter from Michael J. Hogan, Harris Investor Services LLC (``Harris
Letter''); April 29, 2003, letter from Christopher P. Gilkerson,
Vice President and Associate General Counsel, Office of Corporate
Counsel, Charles Schwab & Co. (``Schwab Letter''); May 1, 2003,
letter from Scott W. Campbell, Executive Vice President and General
Counsel, Financial Engines, Inc. (``FE Letter''); May 7, 2003,
letter from Eliot Wagner, Chair, Technology & Regulation Committee,
and Hardy Callcott, Chair, Online Brokerage Legal Committee,
Securities Industry Association (``SIA Letter''); and May 9, 2003,
letter from John M. Ramsay, Senior Vice President and Regulatory
Counsel, The Bond Market Association (``BMA Letter'').
\9\ The FE Letter expressed approval of the proposed rule change
(asserting the proposed rule change ``will benefit investors and
enhance competition in the securities industry''). FE Letter at 1.
The Fidelity, ICI, Schwab, SIA, and BMA Letters expressed approval
of the proposed rule change with modifications. The Harris Letter
opposed the proposed rule change.
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NASD Should Revise the Definition of Investment Analysis
Tools
Several commenters suggested that the NASD revise its definition of
investment analysis tools.\10\ One commenter expressed concern that the
proposed definition of investment analysis tools does not clearly
reflect the ``distinction between tools that show a probability that
investing in specific securities or mutual funds will produce
[[Page 60201]]
a desired result and tools that show probabilities as to how classes of
financial assets or style of investing might perform'' (emphasis in
original).\11\ Other commenters suggested that the NASD revise the
definition to allow for tools that present a single probability of
achieving a desired result, rather than limiting the definition to
tools that provide a range of probabilities.\12\ These commenters
believed that the presentation of a single probability of achieving a
desired result can be achieved in a fair and balanced manner through
the use of disclosure and/or tool functionality.\13\
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\10\ Fidelity Letter at 3; Schwab Letter at 2-4; SIA Letter at
4; BMA Letter at 2-4, 6; Harris Letter at 13. Amendment No. 1
defined an investment analysis tool as ``an interactive
technological tool that produces simulations and statistical
analyses that present a range of probabilities that various
investment outcomes might occur, thereby serving as an additional
resource to investors in the evaluation of the potential risks of
and returns on particular investments.'' Amendment No. 1 at 3.
\11\ Fidelity Letter at 3. Though the commenter noted that the
distinction is indicated in the IM's first footnote, the commenter
recommended that the distinction be recognized in the text of the
definition. Id.
\12\ Id. at 4; Schwab Letter at 4 (``* * * there are tools whose
purpose and use do not include presenting a range of
probabilities.''); SIA Letter at 3.
\13\ See e.g., Fidelity Letter at 4.
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One commenter further suggested that the NASD's proposed definition
of investment analysis tools should be revised so that it fully
reflects the purpose of the IM and explains ``which tools are not
covered by the IM's prescriptive text and therefore are already
permissible under existing [NASD] Rule 2210(d). * * *'' \14\ The
commenter argued that, since several of the proposed investment
analysis tool disclosure requirements ``only make sense if the tool
results in or analyzes investment recommendations,'' investment
analysis tools that analyze a self-directed client's portfolio in light
of a goal provided by the client, such as retirement, and do not make
any investment recommendations should be excluded from the proposed
definition of investment analysis tools.\15\ Additionally, the
commenter recommended that investment analysis tools that registered
representatives currently use internally to make recommendations to
clients (where the tool is not client-facing) also should be excluded
from the NASD's proposed definition of investment analysis tools.\16\
The commenter offered a revised definition of investment analysis
tools, stating that the failure to amend the NASD's proposed definition
``will lead to confusion and inconsistency between past and current
interpretations and practices under different parts of [NASD] Rule
2210(d).'' \17\
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\14\ Schwab Letter at 2.
\15\ Id. at 2-3. See also SIA Letter at 4 (investment analysis
tools that include yield or performance information as part of an
analysis of a client's portfolio in light of client-supplied goals
should be excluded).
\16\ Schwab Letter at 3. See also SIA Letter at 4 (arguing that
investment analysis tools used internally by registered
representatives or investment advisers in the course of preparing
advice for clients should be excluded from the scope of the IM's
prohibition).
\17\ Schwab Letter at 3.
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One commenter suggested that investment analysis tools provided
exclusively to institutional investors should be excluded from the
scope of the proposed IM's prohibition,\18\ while another commenter
encouraged the NASD to revise the definition of investment analysis
tools to clarify that the IM does not apply to bond calculators or risk
management tools used by money managers and institutional investors to
help manage portfolios.\19\ One commenter opined that the definition is
``unnecessarily broad and confusing'' and argued that the NASD tried to
clarify that ``certain `automated educational' [t]ools that present
certain `portfolio analysis' financial planning may not be subject to
the rule, but it appears that portfolio-based planning [t]ools that are
more than `educational' would be subject to the rule.'' \20\
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\18\ SIA Letter at 4.
\19\ BMA Letter at 6.
\20\ Harris Letter at 13.
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NASD Should Clarify the Requirement That Investment
Analysis Tools Use a Mathematical Process That Can Be Audited and
Reviewed
Several commenters suggested that the NASD further explain its
intent with regard to the requirement that investment analysis tools
use a mathematical process that can be audited and reviewed.\21\ The
commenters expressed concern that this requirement could be interpreted
to require member firms to obtain third-party audits of investment
analysis tools.\22\ Two commenters urged the NASD to clarify that it
does not intend for members to collect and maintain an archive of
calculations of each session during which an investment analysis tool
is used.\23\ One commenter noted that some broker-dealers may purchase
their investment analysis tools from third party vendors who may not be
willing to waive confidentiality provisions in licensing agreements
with respect to granting the broker-dealer access to the mathematical
processes of the investment analysis tools.\24\
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\21\ ICI Letter at 3; Fidelity Letter at 5; Harris Letter at 14.
\22\ Fidelity Letter at 5; ICI Letter at 3.
\23\ Schwab Letter at 4 (``The final IM should make clear that
it is only the general mathematical process itself that must be
documented and not the specific calculations generated for any
specific application of the tool.''); Harris Letter at 14 (``No
guidance is provided as to how a member firm must audit the [t]ool,
what features are subject to an audit requirement or whether it
applies on a per client basis.'')
\24\ Harris Letter at 14.
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NASD Should Modify the Requirement to Disclose the
Universe of Investments Considered
Some commenters suggested that the NASD modify its disclosure
requirements to eliminate unnecessary and duplicative disclosure. For
example, several commenters opposed the requirement of a disclosure
statement explaining that there are other investments that were not
considered by the investment analysis tool that may have
characteristics similar or superior to those analyzed by the tool.\25\
One of those commenters suggested that the requirement be revised to
require disclosure only of a description of the universe of investments
considered in the analysis, reasoning that investors ``would likely be
confused by boilerplate disclosure stating that other similar
investments were not considered.'' \26\ One commenter argued that by
requiring disclosure of the universe of investments considered in the
analysis, investors would know that not all investments offered
anywhere were considered.\27\
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\25\ ICI Letter at 3; Harris Letter at 15; Fidelity Letter at 5-
6.
\26\ Fidelity Letter at 6 (``. . .[t]his would give [investors]
the impression that the `grass may be greener' with other
investments, but would fail to provide the investor with any
meaningful analysis.'').
\27\ ICI Letter at 3.
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NASD Should Modify the Proposed Disclosure Requirements
The NASD's proposed disclosure requirements apply not only to
investment analysis tools, but also to written reports indicating the
results generated by the use of investment analysis tools, and any
related sales material. Commenters had varying concerns about this
aspect of the proposal. For example, one commenter advocated an
alternative approach in which the NASD would grant member firms the
discretion to determine the best approach regarding disclosure between
investment analysis tools and the reports generated by use of the
tools, rather than requiring that all written reports contain the same
disclosure, which would be redundant and unhelpful.\28\ The commenter
also suggested that the disclosure requirements not be applied broadly
to all tool-related sales material, but rather be limited to sales
material containing a
[[Page 60202]]
detailed description of the tools as well as investor-specific
probability presentations.\29\ Similarly, another commenter suggested
that, rather than requiring the member firm to make the same disclosure
in all reports and sales material, ``the member could determine where
disclosure of this information would be most appropriate, so long as
the totality of the disclosure provided to the investor includes all
elements of disclosure required by the IM.'' \30\
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\28\ Fidelity Letter at 6. Rather, the commenter recommended
that firms be required to rationalize disclosure between the tool
and the reports, and opined of a greater likelihood that investors
would read the disclosure information if firms are given discretion
in this area. Id.
\29\ Id. at 7-8.
\30\ ICI Letter at 4. See also SIA Letter at 4 (recommending
flexibility in provisions for disclosure and presentation of
information).
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One commenter argued against the NASD's proposal to apply the
disclosure requirements broadly to all investment analysis tool-related
sales material, and recommended that the disclosure requirements apply
only to ``sales material that contains either a detailed description of
the tool or investor-specific probability presentations.'' \31\ Without
this constraint on the scope of the disclosure requirement, the
commenter believed that all pieces of sales material might fall within
the scope of the proposed rule, and therefore be required to comply
with the substantive and disclosure requirements outlined in IM-2210-
(c) and (d). For both written reports and sales material, the commenter
recommended that the NASD allow member firms the flexibility to self-
determine the appropriate disclosure for reports and sales
material.\32\
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\31\ Fidelity Letter at 6-7.
\32\ Id.
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One commenter suggested that the NASD allow members to have
discretion over where to place the required clear and prominent
disclosures ``as part of the tool's interactive process and/or on any
report that provides the tool's result.'' \33\ The commenter encouraged
the NASD to modify the proposed rule to expressly permit both written
and electronic disclosures, ``given that this is a rule about
electronic investment analysis tools.'' \34\ In a general criticism of
the disclosure provision, one commenter suggested that, for most
investment analysis tools, the NASD's mandated conditions and
disclosures ``are unnecessary either because the presentation, purpose
or level of detail of the [t]ool is self evident, or the [t]ool itself
contains sufficient context and disclosure without the additional NASD
requirements.'' \35\
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\33\ Schwab Letter at 4.
\34\ Id.
\35\ Harris Letter at 14.
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NASD Should Modify or Eliminate the 30-Day Pre-Filing and
Approval Requirement
Most of the commenters opposed the NASD's proposed requirement that
member firms provide the NASD with access to a proposed investment
analysis tool at least 30 days prior to its first use, and the required
filing of any templates for written reports produced by, or sales
material concerning, the tool.\36\ One commenter believed that the pre-
use access and filing requirement ``places broker-dealers at a
competitive disadvantage given that investment advisers, mutual funds,
and unregulated financial portals on the Web have no such pre-use
approval process for their investment analysis tools.''\37\ Another
commenter opposed the pre-filing requirement by arguing that it ``would
result in significant delays in the launch of investment tools to
investors.'' \38\ Noting that investment analysis tools can take from
as little as a few months to over a year or more to develop, the
commenter remarked that the pre-use access and filing requirement would
essentially insert the NASD into the development cycle of investment
analysis tools, likely at the final stages of the process. The
commenter argued that this ``will result in member firms devoting a
significant amount of time to negotiating comments with the NASD at the
last stages of development, detracting from focus on launching the tool
with the public.'' \39\ Noting that the NASD does not consider the
approval requirement to be a merit based review, and will instead only
review an investment analysis tool to confirm that the requisite
disclosures have been made, the commenter argued against the need for a
30-day pre-filing and approval requirement.\40\ The commenter suggested
that the NASD conduct its review either ``in due course or after a
member has first used the tool,'' reasoning that ``the proposed review
would be an inefficient extension of the NASD staff's responsibilities,
particularly when the staff is not charged with responsibility of pre-
screening other types of investment tools.'' \41\ Another commenter
remarked that ``the disclosure requirements, as modified, would be
clear enough on their face for members to implement, rendering any
prior review unnecessary.'' \42\
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\36\ Schwab Letter at 5; Fidelity Letter at 7; Harris Letter at
16-18; ICI Letter at 4; SIA Letter at 4.
\37\ Schwab Letter at 5.
\38\ Fidelity Letter at 7.
\39\ Id.
\40\ Id.
\41\ Id.
\42\ Schwab Letter at 6.
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One commenter recommended reducing the 30-day period to a 10-day
period.\43\ Noting that no other provisions of NASD Rule 2210, nor any
other interpretive material issued under the rule, require the filing
of information with the NASD more than 10 days before use, the
commenter remarked that a 10-day pre-filing and approval requirement
``will facilitate the ability of members to utilize their current
internal procedures relating to the review and filing of advertising
and sales literature in connection with the use of these tools.'' \44\
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\43\ ICI Letter at 4.
\44\ Id. Additionally, the commenter recommended that the
filing, approval, and recordkeeping requirements under NASD Rule
2210 not apply to amendments to a tool, related sales material, or
written reports indicating the tool's results that are either non-
substantive or merely updates to preexisting templates that the NASD
previously approved. Id. at 4-5.
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NASD Should Clarify Which Regulatory Regime Applies to the
Use of Investment Analysis Tools
A few commenters expressed concern that the NASD's proposed IM does
not resolve ambiguity regarding which regulatory scheme applies to the
use of investment analysis tools.\45\ Specifically, one commenter
questioned the uncertainty of whether ``the rule prohibiting
predictions and projections, the existing exception to this rule for
hypothetical illustrations of mathematical principles, the exception to
this rule for tools as proposed in the IM, or the rule permitting
forecasts that are not unwarranted and have a reasonable basis''
applies to the use of investment analysis tools.\46\ The same commenter
alleged that the proposed IM took a ``broader historical
interpretation'' of the scope of the NASD Rule 2210(d)(2)(N)
prohibition as applied to investment analysis tools, and suggested that
the language ``be revised to avoid upsetting settled expectations.''
\47\ The commenter noted that many broker-dealers consider their
investment analysis tools to fall under the exception to the general
prohibition of Rule 2110(d)(2)(N) that permits hypothetical
illustrations of mathematical principles.\48\
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\45\ SIA Letter at 2; Harris Letter at 4-19.
\46\ SIA Letter at 2.
\47\ Id. at 4. The SIA Letter recommended that the IM should be
revised to describe the NASD's prior application of the prohibition
as applying to ``communications (generated by a tool or otherwise)
that unfairly implied a specific result, included exaggerated or
unwarranted claims or contained misrepresentations.'' Id. at 5.
\48\ Id. at 3.
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Similarly, one commenter recommended that the NASD explain in more
detail the difference between a permissible ``forecast'' and a
prohibited ``projection or prediction'' and suggested that the IM is
inconsistent
[[Page 60203]]
with prior NASD staff interpretations, which the commenter interpreted
as having previously authorized the use of investment analysis tools,
and takes an unprecedented and overly expansive interpretation of Rule
2110(d)(2)(N).\49\ The same commenter recommended that the NASD
withdraw the proposed IM and instead work to harmonize what the
commenter characterized as inconsistencies within NASD rules and
between NASD and NYSE rules with respect to the terms ``forecast,''
``projection'' and ``prediction,'' where all three terms are, in the
commenter's opinion, sometimes used interchangeably.\50\ The commenter
opined that investment analysis tools should be treated as
``permissible forecasts'' under existing interpretations of Rule
2110(d)(2)(N) and suggested that current NASD rules against exaggerated
or unwarranted claims or misrepresentations already provide adequate
safeguards for the public.\51\
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\49\ Harris Letter at 7-8.
\50\ Id. at 6.
\51\ Id. at 5.
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NASD Should Clarify the Applicability of the IM to
Entities Dually Registered as Investment Advisers
Two commenters requested the NASD to clarify whether a broker-
dealer that also is registered as an investment adviser would be
subject to the provisions of the IM when offering public customers an
investment analysis tool in its capacity as an investment adviser.\52\
One commenter suggested that since investment analysis tools offered by
registered investment advisers are already subject to regulation and
oversight under the regulatory regime applicable to registered
investment advisers, such tools should not be subject to an additional
layer of regulation under the NASD IM when offered through a broker-
dealer to its customers or through a united Web site of a broker-dealer
dually-registered as an adviser.\53\ Similarly, the same commenter
requested the NASD to clarify the applicability of the IM to investment
analysis tools offered by affiliates of a broker-dealer, as well as
non-affiliates and other third parties, including instances where a
broker-dealer's Web site links to such other party's investment
analysis tool.\54\
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\52\ FE Letter at 4 (n. 14); Harris Letter at 11-12).
\53\ Harris Letter at 11-12.
\54\ Id. at 3, 12.
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Undue Burden on Competition
Some commenters objected to what they believe is a potential burden
on competition that could result from the proposed IM, in particular
the pre-filing and approval process.\55\ The commenters were concerned
that the IM could affect the ability of NASD-member firms to compete
with investment advisers, banks, financial planners, financial Web
sites, non-NASD broker-dealers and other non-regulated entities that
would not be subject to the pre-use filing and approval process with
respect to investment analysis tools.
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\55\ See, e.g., Schwab Letter at 5; Harris Letter at 4. But see
FE Letter at 3-5 (asserting that the proposed IM will level the
playing field among investment advisers, broker-dealers and other
financial institutions, increase competition, foster innovation, and
benefit investors).
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One commenter stated that member firms linking customers to an
investment adviser, bank, or other affiliated or non-affiliated third
party offering an investment analysis tool may or may not be subject to
the rule, the uncertainty of which the commenter believes creates
competitive disadvantages for certain classes of member firms depending
on their organizational structure and relationships with third
parties.\56\ Another commenter suggested that the pre-review process
could inhibit the incentive of NASD-member firms to develop proprietary
products tailored to the needs of their customers and favor third-party
vendors who would not be subject to the rule.\57\
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\56\ Harris Letter at 4-5.
\57\ BMA Letter at 5.
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III. The NASD's Response to Comments
The NASD filed Amendment No. 2 on December 3, 2003, which responded
to the comments and elaborated on the NASD's rationale for the proposed
IM. Amendment No. 2 modified the NASD's proposal to accommodate many of
the commenters' concerns.\58\ The NASD's responses to several of the
more significant issues are addressed below.
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\58\ See NASD Response Letter, supra note 6.
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One of the NASD's modifications to the proposed rule was a further
delineation of the types of communications generally prohibited by the
proposed IM. In Amendment No. 2, the NASD modified the proposed IM to
make it consistent with the recently amended language of NASD Rule
2210(d)(1)(D), formerly NASD Rule 2210(d)(2)(N), by clarifying that the
proposed rule change ``prohibits predictions and projections involving
the likely performance of both specific securities and investment
strategies and styles'' (emphasis in original).\59\ Noting that the
dividing line between predictions of specific investments and
investment strategies ``is problematic and no meaningful distinction
can be made from the perspective of investor protection,'' the NASD
broadened the scope of the proposed IM by expanding the definition of
investment analysis tools to allow members to use or offer tools that
present ``the likelihood of various investment outcomes if certain
investments are made or certain investment strategies or styles are
undertaken,'' as long as the member complies with the proposed IM's
requirements.\60\
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\59\ Id. at 2. The initial version of the proposed IM ``focused
on projections of specific securities and did not indicate that
[NASD] Rule 2210(d)(1)(D) also applied to predictions and
projections involving investment strategies and styles.'' Id. An
exception to NASD Rule 2210(d)(1)(D) permits a hypothetical
illustration of mathematical principals, provided that it does not
predict or project the performance of an investment or investment
strategy. See Securities Exchange Act Release No. 47820 (May 9,
2003) (SR-NASD-2000-12), 68 FR 27116, 27123 (May 19, 2003) (adopting
amended NASD Rule 2210).
\60\ NASD Resposne Letter, supra note 6, at 2-3 (emphasis in
original). The revised definition states that an investment analysis
tool is ``an interactive technological tool that produces
simulations and statistical analyses that present the likelihood of
various investment outcomes if certain investments are made or
certain investment strategies or styles are undertaken, thereby
serving as an additional resource to investors in the evaluation of
the potential risks and returns of investment choices.'' Amendment
No. 3, supra note 7, at 2-3.
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In response to commenters' concerns with the pre-filing
requirement, the NASD modified the proposed IM to eliminate the 30-day
pre-filing requirement and instead require members to file their
investment analysis tools with the NASD Advertising Regulation
Department within 10 days after first use. The NASD recognized
commenters' concerns with respect to the NASD interfering in the
development of investment analysis tools and acknowledged that the pre-
filing requirement is unnecessary in light of the fact that the NASD
staff will not be conducting a merit review of the tools.\61\ Further,
the NASD modified the proposed IM to exempt from the 10-day post-use
access and filing requirement members that provide investment analysis
tools exclusively to institutional customers. Such members would,
however, remain subject to the disclosure requirements and would retain
their suitability obligations.\62\ The NASD further modified the
proposed IM to require members to provide the NASD with access to
investment analysis tools or re-file with the NASD the written-report
templates or sales materials only if firms make a material change to
the investment analysis tools,
[[Page 60204]]
written-report templates, or sales materials.\63\
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\61\ NASD Response Letter, supra note 6, at 3.
\62\ Id.
\63\ Id. at 4.
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The NASD also responded to commenters' concerns regarding the
permissibility of calculating a single probability score by amending
the proposed IM to eliminate the requirement that investment analysis
tools present a range of probabilities, including upside, downside, and
median projections.\64\ The NASD recognized that the removal of this
requirement would simplify the proposed IM by eliminating a provision
that did not particularly contribute to the goals of investor
protection.\65\
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\64\ Id.
\65\ Id.
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Similarly, the NASD eliminated the requirement that investment
analysis tools use a mathematical process that can be audited and
reviewed. The NASD recognized the difficulty inherent in requiring NASD
examiners to review the mathematical processes of investment analysis
tools for compliance with the proposed IM. Further, the NASD eliminated
the requirement in order to avoid any perception that may have led the
investing public to believe that the NASD would be performing a merit-
based review of these investment analysis tools.\66\
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\66\ Id.
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The NASD also responded to a suggestion that the NASD standard be
harmonized with New York Stock Exchange Rule 472 that permits forecasts
that are clearly labeled as such and are not exaggerated or
unwarranted.\67\ The NASD explained that ``forecasts'' relate to
estimates of economic performance and results, which is different from
predicting or projecting how a particular investment or investing style
might perform.\68\ Accordingly, the NASD affirmed its belief in
requiring member firms to provide the information specified in the
streamlined disclosure requirements of the amended IM when offering
investment analysis tools, in addition to requiring that the tools not
produce misleading, exaggerated, or unwarranted claims.\69\
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\67\ Id. at 5.
\68\ Id.
\69\ Id.
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With regard to commenters who stated their belief that investment
analysis tools are already permitted by the exception to NASD Rule
2210(d)(2)(N) permitting hypothetical illustrations of mathematical
principles, the NASD explained that amended NASD Rule 2210(d)(1)(D),
formerly NASD Rule 2210(d)(2)(N), operates generally to prohibit
investment analysis tools, as they make predictions and projections
which are prohibited by the rule.\70\ Rather, the hypothetical
illustration exception applies to ``tools that serve the functions of a
calculator that computes the mathematical outcome of certain assumed
variables without predicting the likelihood of either the assumed
variables or the outcome.'' \71\
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\70\ See Securities Exchange Act Release No. 47820 (May 9, 2003)
(SR-NASD-2000-12), 68 FR 27116, 27125 (May 19, 2003) (noting that
the rule permits a member to present a hypothetical illustration of
mathematical principles (e.g., a mutual fund cost calculator), but
would not permit the illustration to predict or project the
performance of an investment or investment strategy, since making a
prediction based on those calculations could be misleading to
investors).
\71\ NASD Response Letter at 5.
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IV. Discussion and Commission Findings
The Commission has reviewed carefully the proposed rule change, the
comment letters, and the NASD's response to the comments, and finds
that the proposed rule change is consistent with the requirements of
the Act and the rules and regulations thereunder applicable to a
national securities association \72\ and, in particular, the
requirements of section 15A(b)(6) of the Act,\73\ which requires, among
other things, that the NASD's 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.
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\72\ In approving this proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
\73\ 15 U.S.C. 78o-3(b)(6).
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In particular, the Commission notes that, in response to
commenters' concerns, the NASD modified the proposed IM to eliminate
the 30-day pre-filing requirement in favor of a 10-day post-use access
and filing requirement. Additionally, the filing requirement is waived
for investment analysis tools provided exclusively to institutional
investors, though the Commission notes that such tools would still be
subject to the disclosure requirements of the proposed IM. The
Commission believes this modification of the proposed IM addresses the
commenters' concerns and that the amended provision is reasonable.
Since the NASD will not be performing substantive merit reviews of
these tools, however, the Commission reminds NASD member firms of the
need to take great care in providing complete and understandable
disclosure to minimize the potential for any investment analysis tool
literature or output to be presented in a misleading manner.\74\
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\74\ The Commission notes that NASD member firms should be
particularly mindful when an investment analysis tool or any report
or sales material derived from such a tool is used in any way that
could be construed as promoting the future performance of one or
more specific investment companies. Tools, reports, or sales
materials that are used in this manner may raise issues under the
antifraud provisions of the federal securities laws and implicate
the investment company advertising rules. See, e.g., 17 CFR
230.156(b)(2) (Rule 156(b)(2) under the Securities Act of 1933
provides that representations about future investment performance
could be misleading under certain circumstances including situations
where representations are made as to possible future gains or
income.).
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With respect to the disclosure regarding the universe of
investments considered by investment analysis tools, the Commission
agrees that the NASD's approach is reasonably tailored to provide
meaningful disclosure regarding the securities considered by the tools
and the limitations inherent in the scope of any analysis provided.
Regarding commenters' concerns about the requirement that investment
analysis tools use a mathematical process that can be audited, the
Commission notes that the NASD has dropped this provision from the
proposed IM. The Commission believes that this modification to the
proposed IM is reasonable. While the Commission acknowledges that the
NASD's modification was intended, in part, to alleviate the commenters'
concerns that the NASD intended for members to collect and maintain an
archive of calculations performed by the tools, or to perhaps require
third-party audits of the tools, the Commission reminds NASD members
that any investment analysis tools purporting to employ mathematical
principles while accounting for certain variables and assumptions
should, by their nature, be capable of being audited with respect to
the processes employed and functions performed by the tools.
Similarly, the Commission notes that the NASD has amended the
proposed IM to remove the requirement that investment analysis tools
present a range of probabilities, thereby allowing tools to present a
single probability of achieving a desired result. While the Commission
believes this modification is reasonable, the Commission reminds
broker-dealers of the importance of meaningful and readily-
understandable disclosure for any investment analysis tools that
present the likelihood of achieving a single result in such a way that
guards against the potential for misleading the investing public.
[[Page 60205]]
In response to one commenter's concerns regarding broker-dealers
dually registered as investment advisers, the Commission notes that the
proposed IM applies only to NASD members. Further, with respect to the
obligations of a broker-dealer for hyperlinked information, the
Commission reminds NASD members of the Commission's guidance regarding
the applicable theories of liability for hyperlinked information.\75\
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\75\ See Securities Exchange Act Release No. 42728 (April 28,
2000), 65 FR 25843 (May 4, 2000) (regarding the entanglement and
adopting theories of liability for hyperlinked information).
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The Commission does not believe that the proposed IM will place any
undue burden on competition. The Commission notes the elimination of
the pre-use filing requirement from the proposed IM and, though
financial advisers and other entities may not be subject to the IM
since the NASD's jurisdiction only extends to its member broker-
dealers, the Commission feels that the amended IM is narrowly tailored
to prevent fraudulent practices and protect the investing public
without unduly restricting or burdening the competitive market for
these types of products with respect to NASD members.
With regard to all other issues raised by the commenters, the
Commission is satisfied that the NASD has adequately addressed the
commenters' concerns.
The Commission expects that the NASD will carefully monitor
compliance with the provisions of the IM among its member broker-
dealers offering investment analysis tools and, in particular, will
review the required disclosures, including the nature of the tools'
output, with an eye towards preventing misleading and fraudulent
statements and protecting the investing public.
The Commission finds good cause for approving Amendment Nos. 2 and
3 before the thirtieth day after the date of publication of notice of
filing thereof in the Federal Register. The NASD filed Amendment No. 2
in response to comments it received after the publication of the notice
of filing of the proposed rule change, to address certain commenters'
concerns and to amend the proposed IM. In addition, the NASD filed
Amendment No. 3 to make minor modifications to the proposed rule
change, including formatting changes and adding references to NASD and
Commission rules and requirements. Because Amendment No. 2 is
responsive to the commenters' concerns and Amendment No. 3 is
responsive to the Commission's suggested modifications, and because
neither Amendment presents any novel issues, the Commission finds good
cause for accelerating approval of Amendment Nos. 2 and 3.
V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing, including whether Amendment Nos. 2
and 3 are consistent with the Act. Comments may be submitted by any of
the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number SR-NASD-2003-13 on the subject line.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609.
All submissions should refer to File No. SR-NASD-2003-13. This file
number should be included on the subject line if e-mail is used. To
help the Commission process and review your comments more efficiently,
please use only one method. The Commission will post all comments on
the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml
). 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 in the Commission's Public Reference Room. Copies of the filing
also will be available for inspection and copying at the principal
office of the Exchange. All comments received will be posted without
change; the Commission does not edit personal identifying information
from submissions. You should submit only information that you wish to
make available publicly. All submissions should refer to file number
SR-NASD-2003-13 and should be submitted on or before October 28, 2004.
VI. Conclusion
It is therefore ordered, pursuant to section 19(b)(2) of the
Act,\76\ that the proposed rule change (SR-NASD-2003-13), as amended by
Amendment No. 1, be, and it hereby is, approved, and that Amendment
Nos. 2 and 3 to the proposed rule change be, and hereby are, approved
on an accelerated basis.
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\76\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation, pursuant
to delegated authority.\77\
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\77\ 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
Exhibit A
* * * * *
Proposed IM-2210-6--Investment Analysis Tools
* * * * *
IM-2210-6. Requirements for the Use of Investment Analysis Tools
(a) General Considerations
This Interpretive Material provides a limited exception to NASD
Rule 2210(d)(1)(D).\1\ No member may imply that NASD endorses or
approves the use of any investment analysis tool or any
recommendation based on such a tool. A member that offers or intends
to offer an investment analysis tool under this Interpretive
Material (whether customers use the member's tool independently or
with assistance from the member) must, within 10 days of first use,
(1) provide NASD's Advertising Regulation Department (Department)
access to the investment analysis tool and (2) file with the
Department any template for written reports produced by, or sales
material concerning, the tool.\2\ The member also must provide any
supplemental information requested by the Department. The Department
may require that the member modify the investment analysis tool,
written-report template or sales material. The Department also may
require that the
[[Page 60206]]
member not offer or continue to offer or use the tool, written-
report template or sales material until all changes specified by the
Department have been made by the member.
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\1\ NASD Rule 2210(d)(1)(D) states that ``[c]ommunications with
the public may not predict or project performance, imply that past
performance will recur or make any exaggerated or unwarranted claim,
opinion or forecast.'' This Interpretive Material allows member
firms to offer investment analysis tools (whether customers use the
member's tool independently or with assistance from the member),
written reports indicating the results generated by such tools and
related sales material in certain circumstances.
Rule 2210(d)(1)(D) does not prohibit, and this Interpretive
Material does not apply to, hypothetical illustrations of
mathematical principles that do not predict or project the
performance of an investment or investment strategy.
\2\ After the Department has reviewed the investment analysis
tool, written-report template or sales material, a member must
notify the Department and provide additional access to the tool and
re-file any template or sales material if it makes a material change
to the presentation of information or disclosures as required by
paragraphs (c) and (d).
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A member that offers an investment analysis tool exclusively to
``institutional investors,'' as defined in Rule 2211(a)(3), is not
subject to the post-use access and filing requirement in this
paragraph if the communications relating to or produced by the tool
meet the criteria for ``institutional sales material,'' as defined
in Rule 2211(a)(2). A member that intends to make the tool available
to, or that intends to use the tool with, any person other than an
institutional investor (such as an employee benefit plan participant
or a retail broker-dealer customer) will be subject to the filing
and access requirements, however.
As in all cases, a member's compliance with this Interpretive
Material does not mean that the member is acting in conformity with
other applicable laws and rules. A member that offers an investment
analysis tool under this Interpretive Material (whether customers
use the member's tool independently or with assistance from the
member) is responsible for ensuring that use of the investment
analysis tool and all recommendations based on the investment
analysis tool (whether made via the automated tool or a written
report) comply, as applicable, with NASD's suitability rule (Rule
2310), the other provisions of Rule 2210 (including, but not limited
to, the principles of fair dealing and good faith, the prohibition
on exaggerated, unwarranted or misleading statements or claims, and
any other applicable filing requirements for advertisements and
sales literature), the federal securities laws (including, but not
limited to, the antifraud provisions), the Securities and Exchange
Commission rules (including, but not limited to, SEC Rule 156 under
the Securities Act of 1933) and other NASD rules.
(b) Definition
For purposes of this Interpretive Material and any
interpretation thereof, an ``investment analysis tool'' is an
interactive technological tool that produces simulations and
statistical analyses that present the likelihood of various
investment outcomes if certain investments are made or certain
investment strategies or styles are undertaken, thereby serving as
an additional resource to investors in the evaluation of the
potential risks and returns of investment choices.
(c) Use of Investment Analysis Tools and Related Written Reports
and Sales Material
A member may provide an investment analysis tool (whether
customers use the member's tool independently or with assistance
from the member), written reports indicating the results generated
by such tool and related sales material\3\ only if:
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\3\ Sales material that contains an incidental reference to an
investment analysis tool (e.g., a brochure that merely mentions a
member's tool as one of the services offered by the member) need not
include the disclosures required by this Interpretive Material and
would not need to be filed with the Department, unless otherwise
required by the other provisions of Rule 2210.
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(1) The member describes the criteria and methodology used,
including the investment analysis tool's limitations and key
assumptions;
(2) the member explains that results may vary with each use and
over time;
(3) if applicable, the member describes the universe of
investments considered in the analysis, explains how the tool
determines which securities to select, discloses if the tool favors
certain securities and, if so, explains the reason for the
selectivity,\4\ and states that other investments not considered may
have characteristics similar or superior to those being analyzed;
and
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\4\ This disclosure must indicate, among other things, whether
the investment analysis tool searches, analyzes or in any way favors
certain securities within the universe of securities considered
based on revenue received by the member in connection with the sale
of those securities or based on relationships or understandings
between the member and the entity that created the investment
analysis tool. The disclosure also must indicate whether the
investment analysis tool is limited to searching, analyzing or in
any way favoring securities in which the member makes a market or
has any other direct or indirect interest. Members are not required
to provide a ``negative'' disclosure (i.e., a disclosure indicating
that the tool does not favor certain securities).
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(4) the member displays the following additional disclosure:
``IMPORTANT: The projections or other information generated by [name
of investment analysis tool] regarding the likelihood of various
investment outcomes are hypothetical in nature, do not reflect
actual investment results and are not guarantees of future
results.''
(d) Disclosures
The disclosures and other required information discussed in
paragraph (c) must be clear and prominent and must be in written or
electronic narrative form.
* * * * *
[FR Doc. E4-2529 Filed 10-6-04; 8:45 am]
BILLING CODE 8010-01-P