Investment Management
MARCH 2004
The SEC’s Proposed Confirmation and Point-of-Sale
Disclosure Requirements
INTRODUCTION
The Securities and Exchange Commission (“SEC”)
proposed two new rules and related schedules that
would prescribe a complex set of disclosure
obligations for transactions in shares of open-end
management investment companies, interests in
variable insurance products, and municipal fund
securities commonly known as 529 plans
(collectively, “covered securities”).1 The proposed
rules apply to brokers, dealers, and municipal
securities brokers and dealers (collectively, “brokerdealers”) that effect transactions in covered
securities for customers, including all broker-dealers
in the chain of a covered securities transaction
(e.g., clearing broker-dealers).2 If adopted, the rules
would require the disclosure of material transaction
information, as described below, in a customer
confirmation and in a “point-of-sale” document (and
orally) prior to the execution of customer
transactions in a covered security.
The proposal, in part, responds to recent events in
the mutual fund industry concerning well-publicized
alleged incidents of undisclosed or poorly disclosed
fee arrangements and conflicts of interest in
connection with the distribution of mutual fund
shares. It also reflects the long-term evolution of the
SEC’s disclosure regime in the context of mutual fund
and variable insurance product transactions. The
proposed rules, Rule 15c2-2 and Rule 15c2-3 under
the Exchange Act, establish a separate disclosure
regime from the SEC’s long-standing confirmation
rule, Rule 10b-10. The goal of this separate
disclosure regime is to (1) tailor a broker-dealer’s
disclosure obligations to potentially unique conflicts
associated with the distribution of covered securities
and (2) provide greater transparency of the overall
costs associated with investments in a covered
security, as well as the effects on fund performance
of these distribution costs. Rule 10b-10 would
continue to apply to the disclosure obligations
associated with transactions in securities other than
covered securities.
As part of this particular rulemaking effort, the SEC
also proposed amendments to Form N-1A, the
registration form for open-end investment
management companies, in order to enhance the fee
table disclosure of sales loads and revenue sharing
arrangements. The Proposing Release sets forth the
SEC’s proposed amendments to Rule 10b-10, not only
to conform it to the requirements of proposed Rules
15c2-2 and 15c2-3, but also to require certain
disclosures relating to callable preferred stock and
callable debt securities.
1 The proposed rules and schedules, if adopted, would be codified in Rule 15c2-2 and Rule 15c2-3, as well as Schedule 15C
and Schedule 15D, under the Securities Exchange Act of 1934 (“Exchange Act”). The SEC published the proposal in
Securities Exchange Act Release No. 49148 (Jan. 29, 2004) (“Proposing Release”). The proposals do not apply to
exchange-traded funds (“ETFs”) or closed-end investment companies, including interval funds that may have
characteristics similar to an open-end management investment company. The SEC did, however, request comment on
whether the proposals should extend to ETFs and closed-end investment companies.
2 A single confirmation may still be delivered to a customer, but the compensation to each broker-dealer must be identified.
Kirkpatrick & Lockhart LLP
The discussion below is limited to the proposed
disclosure obligations under Rule 15c2-2 and Rule
15c2-3, as well as the related schedules.
The proposed rules currently are subject to public
comment. The comment period expires April 12, 2004.
RULE 15C2-2 CONFIRMATION DISCLOSURE
REQUIREMENTS
The proposed disclosure requirements of Rule 15c2-2
replace a 1979 SEC staff no-action letter issued to the
Investment Company Institute.3 The ICI Letter
basically waived certain confirmation fee disclosure
requirements for mutual fund transactions on the
condition that the fund prospectus set forth the
precise fee information, thereby permitting investors
to identify the loads and any other fund fees charged
for their transactions.
In 1994, the SEC staff announced its intent to
withdraw the ICI Letter in recognition of the
significant expansion of the mutual fund industry and
the evolution of fee structures from front-end load
funds to more complex alternative fee structures.4
The staff ultimately declined to withdraw the ICI
Letter at that time in view of the arguments from the
mutual fund industry that the fee table and
prospectus provided more meaningful and
comprehensive disclosure of fees than the
confirmation, particularly in cases of contingent
deferred sales loads and 12b-1 fees. In a recent court
decision, Press v. Quick and Reilly,5 the SEC
reaffirmed this position in an amicus brief, noting
that, at least in the case of a mutual fund transaction,
a fund prospectus may be a viable alternative to a
transaction confirmation.
Proposed Rule 15c2-2 sends the clear message that
the SEC believes confirmation disclosure is an
important supplement to, and in no way redundant
of, prospectus disclosure. That is, the SEC no longer
believes that prospectus disclosure alone suffices to
convey material information about the overall costs
and conflicts of interest potentially related to an
investment in a covered security. The proposed fee
disclosure also significantly expands on the fee
disclosure that would otherwise be required under
Rule 10b-10. In this regard, the Proposing Release
announced the SEC’s formal intention to withdraw
the ICI Letter and to respond to the disclosure
concerns expressed by the Quick & Reilly court.
General Disclosure Information
Proposed Rule 15c2-2 would require confirmation
disclosure of the following basic transaction
information:
n
Date of the transaction;
n
Issuer and class of security;
n
Net asset value of the covered securities, and if
different, their public offering price;
n
Number of shares or units purchased or sold;
n
Total dollar amount paid or received;
n
Net amount of the investment bought or sold
(reflected as the number of shares or units bought
or sold times the net asset value);
n
Any commission, markup or other remuneration
the broker-dealer will receive from the customer,
and in the case of a customer redemption of
shares or units assessing a contingent deferred
sales load, the amount of the load incurred by the
customer; and
n
Status under the Securities Investor Protection
Corporation (SIPC) except in the certain fund
direct transactions where customer funds,
redemptions, and confirmations are processed
directly between the customer and the fund or
agent of the fund and the fund or agent is not
affiliated with the broker-dealer.
These general disclosure requirements (other than
the absence of disclosing the capacity of the brokerdealer and the disclosure of deferred sales loads)
essentially incorporate basic disclosure obligations
prescribed by Rule 10b-10.
Specific Disclosures Relating to Purchases
Proposed Rule 15c2-2 prescribes fee-related
disclosure obligations with respect to (1) front-end
and deferred sales loads and breakpoint discounts;
(2) dealer concessions (i.e., fees paid at the time of
sale to the broker-dealer, typically by a fund’s
3 SEC No-Action Letter (pub. avail. Apr. 18, 1979) (the “ICI Letter”).
4 Letter to the Investment Company Institute, dated March 16, 1994.
5 218 F.3d 121 (2nd Cir. 2000).
Kirkpatrick & Lockhart LLP
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principal underwriter); (3) asset-based sales charges;
(4) revenue sharing and portfolio brokerage
payments paid to the broker-dealer; (5) differential
compensation paid to an associated person of the
broker-dealer, such as a registered representative;
and (6) certain comparative information.
Disclosure of Loads and Breakpoints
As proposed, the rule would require the broker-dealer
to disclose, at the time of purchase, the amount of a
sales load imposed on the customer’s transaction in
dollars and as a percentage of the amount invested.
This is intended as a separate disclosure item to the
commission disclosure required as part of the general
disclosure items.
If a front-end load is imposed, the confirmation must
disclose breakpoint information, including the
amount of the sales load in light of available
breakpoint discounts. For transactions in which a
front-end load is not assessed, the confirmation
generally would need to disclose: (1) the potential
amount of any deferred sales load (the maximum
incurred both in dollars and as a percentage of net
asset value at purchase or sale) that would be
incurred should the customer sell the covered
security; and (2) the amount of a front-end load that
would have been charged hypothetically had the
customer purchased a class of shares or units
imposing such a load. Presumably, this disclosure is
intended to highlight certain suitability issues with
respect to recommending certain classes of shares
that may in actuality be more expensive to an
investor, although no identifiable sales load is
disclosed at the time of the customer’s purchase.
The National Association of Securities Dealers, Inc.
(“NASD”) has addressed these suitability issues
previously in several publications6 and an
administrative action requiring, among other things,
that a broker-dealer review its policies and
procedures concerning the recommendation of multiclass products.7
In examining these proposals, a broker-dealer should
consider the value that hypothetical information of
this nature provides to a customer in a confirmation
after the customer’s investment decision has been
made. A broker-dealer will need to consider the extent
to which the disclosure could be confusing.
Arguably, disclosure of this nature, if made at all,
would appear to be more valuable if made prior to the
customer’s decision to invest and as part of the
duties owed to a customer when a broker-dealer
recommends a covered security. As discussed in
more detail below under “Antifraud Implications,”
hypothetical disclosure also could have significant
antifraud implications for a broker-dealer.
Dealer Concessions
As proposed, the rule would require the disclosure of
dealer concessions paid to broker-dealers both in
terms of dollars and as a percentage of the net
amount invested. Because the term dealer
concessions is defined as payments to the brokerdealer from an issuer (its agent), principal distributor,
or other broker-dealer, they are distinguishable from
commissions and loads that are paid from the
customer’s investment. The SEC believes that this
fee disclosure is necessary because it highlights the
extent of the overall financial stake that a brokerdealer may have in recommending particular covered
securities.
Asset-Based Sales Charges and AssetBased Service Fees
As proposed, the rule would require the disclosure of
information related to the payment of annual assetbased sales charges and asset-based service fees as
a percentage of net asset value. The proposal does
not require the disclosure of the actual amounts of
asset-based fees in terms of dollars (a broker-dealer
is unlikely to know in advance these amounts), but it
would require the broker-dealer to disclose an
estimate of the total annual dollar amount based on
net asset value, assuming net asset value did not
change presumably at the time of the customer’s
transaction. This disclosure extends to transactions
in which dedicated mutual funds to a 529 plan or
variable insurance separate account assess assetbased sales charges or asset-based service fees,
even though the 529 plan or variable insurance
separate account itself does not.
6 See, e.g., NASD Notice to Members 95-80 (Sept. 1995).
7 See In the Matter of Morgan Stanley DW Inc., Securities Exchange Act Release No. 48789 (Nov. 17, 2003).
Kirkpatrick & Lockhart LLP
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The rule defines the term “asset-based sales charge”
as all asset-based charges paid in connection with
the distribution of covered securities either paid
directly by the issuer or out of the assets of covered
securities owned by the issuer (e.g., 529 plan or
variable insurance separate account). Similarly, the
term “asset-based service fees” is defined as assetbased fees paid for personal service and/or
maintenance of shareholder accounts. This
definition would apply to 12b-1 fees and other assetbased fees paid for distribution or for so-called
“shareholder services.”8
Revenue Sharing Arrangements
As proposed, the rule would require a complex set of
disclosures related to payments to a broker-dealer (or
in some cases an affiliated broker-dealer or other
non-broker-dealer affiliate) pursuant to a revenue
sharing arrangement or in connection with the
broker-dealer’s execution of the portfolio securities of
a fund complex. This proposed disclosure is intended
to set forth quantifiable information and significantly
expands the generic prospectus disclosure about
revenue sharing arrangements and potential conflicts
related to fund portfolio brokerage as a potential quid
pro quo to be on a broker-dealer’s preferred list. The
proposal also requires disclosure relating to amounts
received by a broker-dealer in connection with the
execution of a fund’s portfolio transactions,
regardless if payment is in the form of commissions
or remuneration for riskless principal transactions.
Certain fee arrangements are not intended to be
covered under this disclosure obligation. For
instance, dealer concessions would be disclosed
under separate requirements. Payments from an
issuer also are not included in the proposed revenue
sharing disclosure.
The disclosure is complex and prescribes a difficult
calculation formula. Very generally, broker-dealers
subject to this provision must disclose amounts
received as a percentage of the cumulative net asset
value for all sales of covered securities for a fund
complex over the four most recent calendar quarters.
A broker-dealer participating in a revenue sharing
arrangement must disclose the total amount of
remuneration it expects to receive under a revenue
sharing arrangement. Similarly, a broker-dealer
executing fund portfolio transactions must disclose
the total dollar amount of remuneration that it expects
to receive for portfolio brokerage transactions.
Differential Compensation
As proposed, the rule would require a broker-dealer
to disclose if its associated persons were paid more
for sales of covered securities charging certain
deferred sales loads or for proprietary covered
securities (i.e., covered securities issued by an
affiliated issuer) than for other covered securities
investments offered by the broker-dealer. This
disclosure would be in a “check-the-box” format
either as a “yes,” “no,” or “not applicable.” The
NASD also has proposed regulations governing
revenue sharing and differential compensation
payments in connection with sales of mutual fund
shares only, which disclosure would be made at the
account opening of the first purchase of mutual fund
shares.9
Comparative Information
As proposed, a broker-dealer would be required to
disclose comparative information that is intended to
measure the fees paid to the broker-dealer compared
to an industry mean based on specified percentages
and information published periodically by the SEC.
The SEC would require updating of this complex
disclosure within 90 days of the SEC’s publication of
the comparative information. The SEC acknowledged
that, for this proposal to take effect, new rulemaking
would be required as a precondition to gathering the
appropriate industry information.
Periodic Reporting
As proposed, periodic confirmations could be
delivered in lieu of immediate confirmations just as
they are permitted under Rule 10b-10. Currently,
paragraph (b) of Rule 10b-10 sets forth the conditions
under which a broker-dealer may send a monthly or
quarterly confirmation in lieu of an immediate
confirmation. This periodic alternative currently
applies to transactions in shares of a money market
fund (a fund that complies with Rule 2a-7 of the
Investment Company Act of 1940), such as under a
sweep arrangement, or transactions pursuant to
9 NASD Notice to Members 03-54 (September 2003).
1 0 See, e.g., Metropolitan Life Insurance Company, SEC No-Action Letter (pub. avail. Apr. 3, 1995).
Kirkpatrick & Lockhart LLP
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“investment company plans,” which the proposal
redefines as a “covered securities plan.” These plans
are associated with employee benefit plans where
employee contributions are automatically deducted
monthly or semi-monthly and invested in covered
securities at a set date and in a set amount.
The definition of “covered securities plan” is
virtually identical to the definition of investment
company plan currently in Rule 10b-10 and sets forth
certain reporting and confirmations under a so-called
10-day rule. Several life insurance companies
obtained exemptions under Rule 10b-10 for
procedures that establish an alternative to the
reporting procedures prescribed by the 10-day rule.10
The SEC did not specify if these exemptions would
be maintained and, therefore, extend to transactions
covered under new Rule 15c2-2 or if new exemptions
would need to be granted under the new rule.
Schedule 15C
Schedule 15C sets forth the SEC’s uniform format that
the proposed disclosure under Rule 15c2-2 must
follow.
RULE 15C2-3 POINT-OF-SALE DISCLOSURE
REQUIREMENTS
The SEC also proposed a companion rule to the
SEC’s proposed confirmation rule, Rule 15c2-3 and
related Schedule D, that, unless otherwise excepted,
would require certain pre-transaction disclosure to a
customer in the case of a purchase of a covered
security. The proposed point-of-sale disclosure
applies if the transaction is solicited or unsolicited.
As proposed, the timing of this disclosure generally
must be immediately prior to the time the brokerdealer accepts an order for covered securities from a
customer. In cases in which a customer does not
open an account with the broker-dealer or in the case
in which the broker-dealer does not accept an order
from the customer, the point-of-sale disclosure is at
the time the broker-dealer first communicates with the
customer about the covered security. Until the
customer has received this point-of-sale disclosure
and has had the opportunity to reaffirm his or her
order, the broker-dealer has not received an order per
se but merely an indication of interest.
Disclosure Information
As proposed, the rule would require disclosure about
(1) the sales loads at the time of purchase; (2) an
estimate of asset-based sales fees and asset-based
service fees over the year following the brokerdealer’s sale; (3) an estimate of the amount of the
maximum deferred sales load associated with the
purchase if the customer redeems securities within
one year from the customer’s purchase; (4) the
number of years that a deferred sales load would be
in effect; and (5) the amount of dealer concessions to
the broker-dealer. Each of the categories of
disclosure must be in reference to the value of the
customer’s purchase or, if the value cannot be
estimated, the disclosure must reflect the effect of
sales loads, fees, or dealer concessions on a
hypothetical purchase of $10,000 of covered
securities.
The proposal also would require disclosure of the
extent to which a broker-dealer (or affiliate) receives
revenue sharing compensation or portfolio brokerage
compensation from a fund complex, and whether the
associated person of the broker-dealer received
differential compensation under the circumstances
identified in proposed Rule 15c2-2.
Manner of Disclosure
The proposed point-of-sale disclosure must be made
in writing in accordance with the format set forth in
Schedule D and oral disclosure for any in-person
meeting between the broker-dealer’s associated
person and the customer. If the point of sale is via a
series of oral communications not involving an inperson meeting, such as over the telephone, then the
disclosure may be made orally in the absence of a
written disclosure document.
Exceptions to the Point-of-Sale Disclosure
The proposed rule sets forth five exceptions to the
application of the point-of-sale disclosure. The
proposed rule imposes two unconditional exceptions
for (1) transactions pursuant to a dividend
reinvestment plan; and (2) transactions in which the
broker-dealer exercises investment discretion for the
customer. The proposed rule contains three
conditional exceptions for (1) customer mail or
messenger transactions to the extent that the
transaction is a fund-direct transaction and the
broker-dealer has not formally opened an account for
the customer and does not receive compensation; the
customer must also receive within the previous six
months the disclosure required by Rule 15c2-3;
(2) transactions in which the clearing broker-dealer or
mutual fund distributor acts merely as an order taker
Kirkpatrick & Lockhart LLP
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and has a reasonable belief that the broker-dealer
that communicated with the client delivered the
required point-of-sale disclosure; and
(3) transactions involving “covered securities plans,”
as defined in proposed Rule 15c2-2, to the extent that
point-of-sale disclosure was delivered prior to the
first transaction for the covered securities plan.
The exception for “covered securities plans” raises
interesting issues considering that these plans
typically are pursuant to employee benefit plan
transactions. For purposes of Rule 10b-10, the SEC
has historically viewed the plan, when the
shareholder of record, and not each participant of the
plan, as the customer.11 That is, the plan sponsor,
and not each participant, would receive periodic
confirmations under Rule 10b-10. Inasmuch as neither
proposed Rule 15c2-2 nor proposed Rule 15c2-3
defines customer to include plan participants, the
application of the conditional exception for covered
securities plans begs the question as to who the
recipient of the point-of-sale disclosure must be in
the first instance—the plan sponsor or plan
participant. The SEC did not address this issue in
the Proposing Release.
ANTIFRAUD IMPLICATIONS
Both of the proposed rules contain a preliminary
statement that clarifies that the required disclosures
set forth the minimum that may be required in a
covered securities transaction. That is, neither of the
rules is a safe harbor to the general antifraud
provisions of Section 10(b) of the Exchange Act and
Rule 10b-5 under the Exchange Act. This note could
raise difficult antifraud issues for broker-dealers
required to disclose hypothetical sales load
information, estimated asset-based sales and service
fees, and estimated revenue sharing and portfolio
brokerage amounts. To the extent that the SEC has
specifically identified these fee arrangements as
material to a customer, a broker-dealer presumably
has antifraud exposure if the hypothetical or
estimated information is slightly or significantly off
the mark. The SEC did not address these issues or
establish any form of safe harbor under the proposals
requiring disclosure of information not otherwise
known to the broker-dealer prior to, or at the time of,
a customer’s transaction in covered securities.
C. DIRK PETERSON
202.778.9324
dpeterson@kl.com
1 1 See Securities Exchange Act Release No. 13508 (May 5, 1977), n.24.
Kirkpatrick & Lockhart LLP
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Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal
counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund
complexes. No law firm was mentioned more frequently in the Scorecard.
We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly
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variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
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We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
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© 2004 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.