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News June 13, 2011 Issue

Three Strikes And You’re Out? FINRA Still Swinging For Revisions To The Mutual Fund Cash Compensation Rule

It’s premature, it creates inconsistencies, and it promotes investor confusion.

That is the message FINRA has been getting about its proposal to revise NASD Rule 2830, the mutual fund cash compensation disclosure rule, which is currently before the SEC for approval. Now that message has been delivered to the SEC.

NASD Rule 2830 is the long-standing conflicts disclosure rule that is designed to ensure that investors understand how the broker selling them various mutual fund products is compensated. The rule requires investment companies to provide prospectus disclosure of certain special compensation arrangements other than sales charges and services fees listed in the fee table.

The latest round of proposed revisions to the rule, which would become new FINRA Rule 2341, would shift the disclosure obligation for special compensation arrangements to the broker-dealers that sell investment company securities. Under the rule as currently proposed, broker-dealers would be required to provide pre-sale disclosures to investors and to maintain a web page or toll-free number providing additional information.

Additionally, the proposal would also deem certain revenue sharing arrangements as cash compensation that must be disclosed. Also, existing customers would receive a one-time disclosure related to their current fund investments.

NASD Rule 2830 applies to special compensation arrangements related to sales of mutual fund shares, and similar NASD Rule 2320 applies to special compensation arrangements related to variable insurance contracts. FINRA has long interpreted that Rule 2830 does not apply to the mutual funds that underlie separate accounts for variable insurance contracts to avoid a duplicative disclosure burden. The annuity industry anticipates that FINRA will likely seek to propose changes to Rule 2320 that comport with the changes in the current proposal.

In 2003, the proposed revisions to include point-of-sale disclosures failed outright and were withdrawn. In 2009, the proposal was revived, and after a lengthy comment and review period, FINRA further revised the proposal and forwarded it April to the SEC for action. Last month, the SEC solicited its own comments on FINRA’s proposal.

Here’s what industry participants and representatives had to say.

The rule is premature, and should be sidelined until the SEC determines how to coordinate implementing multiple disclosure initiatives directed at broker-dealers and their customers.

The SEC is currently considering a number of initiatives related to retail investment product disclosures and related conflicts of interest, noted a number of commenters, including the Investment Company Institute (ICI), Committee of Annuity Insurers, the Independent Directors Council (IDC), SIFMA, and the Financial Services Institute (FSI).

Dodd-Frank Act (DFA) Section 919 point-of-sale conflicts and compensation disclosures, Rule 12b-1 reform, DFA Section 917 investor financial literacy and education, and DFA Section 913 harmonization of the obligations of broker-dealers and advisers are all on the SEC’s radar. The Department of Labor maintains compensation disclosure requirements under ERISA Section 408(b)(2) and has proposed revising the definition of fiduciary. FINRA itself has issued a concept release for a broker-dealer brochure very similar to the brochure that advisers produce under Form ADV Part 2.

FINRA and the SEC should take a comprehensive approach to the issues, observed a majority of the commenters, and not a one-step-forward-two-steps-back approach that would be costly, burdensome, potentially duplicative and potentially unnecessary.

"With all of the attention currently being given to improving the content, timing and method of disclosure by broker-dealers to retail investors, we question whether it is appropriate for FINRA to move forward with the current proposal at this time. We recommend that the Commission consider whether the current proposal can be absorbed readily into one or more of these broader initiatives, or whether it may soon be rendered moot, duplicative, or in need of extensive revisions, based on their results," said ICI general counsel Karrie McMillan.

"If the Commission or FINRA move forward with new broad-based investor protection initiatives following approval and implementation of the Proposed Rule, investors may receive duplicative or even contradictory disclosures that have the potential to confuse investors, which is contrary to FINRA’s objective and the purpose of the Proposed Rule," said Charles Schwab CCO Bari Havlik.

"We are unclear," said IDC chair Dorothy Berry, "why the SEC and FINRA aare pursuing this narrow change at this time, when broader point-of-sale initiatives that could provide more comprehensive and meaningful information to investors are underway."

The rule unfairly focuses on mutual funds alone.

"[W]e believe relevant disclosure should be required for all retail investment products sold by financial intermediaries, including variable annuity contracts and separate accounts, not just mutual funds. Failure to extend disclosure requirements to competing retail products could unfairly disadvantage mutual funds and provide perverse incentives for brokers to sell other, potentially less suitable products." said McMillan.

"[F]or comprehensive point-of-sale disclosure to truly benefit mutual fund shareholders, it must, in contrast to FINRA’s current proposal, extend to all investment products and services," said Berry. Requiring such disclosures only of mutual funds would establish disincentives for broker-dealers to offer funds to their customers and also harm investors trying to make informed investment decisions.

If the rule proposal is adopted, it will result in a discriminatory, "unlevel playing field for mutual funds" that would put them at a competitive disadvantage to other products or investments sold through a broker-dealer, said FSI general counsel David Bellaire.

Changes to the definition of "revenue sharing" do not match up with SEC interpretation.

"[T]he revenue sharing definition differs from the definition of revenue sharing that has been followed by the SEC in various enforcement actions," said the Committee of Annuity Insurers. Specifically, payments covered by non-cash compensation provisions are excluded from the definition of revenue sharing by the SEC, but would be included in FINRA’s proposed rule. "The Committee believes that many institutions have structured their programs to align with the SEC approach."

Further, said the Committee, if the rule change is adopted, the revenue sharing definition will differ from the definition in Rule 2320, creating conflict in the FINRA rulebook itself.

The rule as proposed will lead to information overload for investors.

For instance, said LPL Financial general counsel Stephanie Brown, LPL would need to disclose networking arrangements, omnibus servicing arrangements, revenue sharing payments, additional payments for educational and marketing support and any other fees it may receive from investment company complexes. Instead of a weighted – and abbreviated – list of funds that pay revenue sharing that is not tied to the servicing of an account as it does now, LPL will be forced to disclose a "laundry list" of all the investment company securities sold by the firm. The rule as proposed would have a dilutive effect on the existing disclosure that was intended to address actual conflicts of interest. "The previously useful disclosure will have become lost in the encyclopedia of fee disclosure the Proposal would create."

The lone commenter claiming to directly represent investor interests, the Public Investors Arbitration Bar Association (PIABA), urged approval of the rule "because it will incrementally improve disclosure concerning brokerage firms’ financial incentives to recommend certain mutual funds over other investments." PIABA also urged FINRA to go a step further and consider limiting financial incentives to the sales charges and service fees already disclosed in the mutual fund prospectus.

The SEC has asked FINRA to respond to the public comments submitted on this most recent version of its cash compensation rule. The SEC will then take action to approve, disapprove, or delay the proposal, and has until August 5 to determine which way it will go.