In June 2009, FINRA issued Notice 09-34, proposing new FINRA Rule 2341 regarding the distribution and sale of investment company securities. NASD Rule 2830 currently regulates member firms’ activities in connection with the distribution and sale of investment company securities. The proposed rule adds some significant new disclosures to investors regarding the receipt of cash compensation by broker-dealers. These disclosure changes would be required to be reflected in fund prospectuses. A copy of Notice 09-34 is available at http://www.finra.org/Industry/Regulation/Notices/2009/P119014.

Proposed Changes to Prospectus Disclosure

The proposed rule modifies the cash compensation provisions of NASD Rule 2830(l), including provisions relating to prospectus disclosure. The proposal conflicts with the SEC’s recent amendments to Form N-1A, which require only a general statement regarding financial intermediary compensation. Although FINRA has jurisdiction only over broker-dealers, because FINRA forbids broker-dealers from selling or distributing securities whose prospectuses do not contain the information required by FINRA, its rules can effectively control investment company prospectus disclosure.

First, the proposed rule requires that standard “sales charges and service fees,” rather than all cash compensation, be described in the prospectus. Second, the proposed rule eliminates the term “special cash compensation” and instead requires prospectus disclosure where a member firm received greater (or special) sales charges or service fees than are ordinarily paid in connection with sales of fund shares.

The proposed rule also includes new interpretative material expanding the definition of cash compensation and special arrangements. Under the new interpretations, cash compensation includes revenue sharing paid in connection with the sale and distribution of investment company securities (and therefore member firms would be required to disclose revenue sharing arrangements pursuant to the rule). The new interpretations also clarify that a special sales charge or service fee arrangement include any arrangement under which a member firm receives greater sales charges or service fees than other member firms selling the same investment company securities, even if an offeror would have made the same arrangement available to other member firms had they requested it.

Realistically, it is impossible for a broker-dealer to know whether an investment company has different compensation arrangements with its other broker-dealers. Therefore, if the proposed rule goes into effect, broker-dealers will likely seek to modify contractual arrangements with each investment company available on their platforms and require representations from each investment company that it makes the required prospectus disclosures regarding such special arrangements.

Proposed Changes to Broker-Dealer Disclosure

The proposed rule also adds new disclosure requirements for broker-dealers that offer investment company securities. A member firm that receives cash payments in addition to the standard sales charges and service fees would have to:

  1. Disclose that information about a fund’s fees and expenses may be found in the fund’s prospectus;
  2. If applicable, disclose the following:
  • That the firm receives cash payments from offerors in addition to the standard sales charges and service fees disclosed in the prospectus;
  • The nature of such payments received in the last 12 months; and
  • A list of the offerors making such payments listed in descending order of payments received; and  
  1. Provide a reference to a web page or toll-free number containing updated information, which must be updated at least every six months. Alternatively, it must disclose updated information to customers every six months.

Written disclosure would initially need to be provided at the time the account is opened or at the time of a customer’s first purchase of an investment company security. For existing accounts, member firms would have to provide the written disclosure within 90 days of the adoption of the rule or at the time of the customer’s next purchase of an investment company security.