JOINT SEC/NASD
REPORT
ON EXAMINATION
FINDINGS REGARDING BROKER-DEALER SALES OF VARIABLE INSURANCE PRODUCTS
Office of Compliance Inspections and Examinations
United States Securities and Exchange Commission
I. EXECUTIVE SUMMARY
Variable annuity and variable life insurance products
(collectively, “variable insurance products" or “variable products”) are
being marketed and sold to a large number of investors. While variable insurance products may be
appropriate investments for some investors, concerns have been raised about the
sale of these products. This prompted
the staffs of the Securities and Exchange Commission (“SEC” or “Commission”)
and NASD (“Staff”) to conduct examinations of broker-dealers that sell variable
insurance products. This report
summarizes the findings of those examinations.
Variable insurance products are hybrid investments
containing both securities and insurance features. The insurance features of variable annuities permit the investor
to receive a series of periodic payments from the investment over time and
provide a death benefit to the beneficiary should the investor die during the
accumulation phase. Variable life
policies are a form of life insurance.
The insurance features of both products provide tax-deferred treatment
of any accumulated earnings. In both
variable annuity and variable life products, the securities feature provides
the investor with an opportunity to participate in potential capital
appreciation and income through investments in the securities markets, but also
subjects the investor to market risks.
Variable insurance products, as securities under the federal
securities laws and insurance under state insurance laws, are sold jointly
through broker-dealers and insurance agencies.
In selling securities, broker-dealers must comply with a number of
requirements including having reasonable grounds for believing that the
recommendation is suitable for the investor, providing adequate supervision
over salespersons, ensuring that adequate disclosure is made to customers, and
maintaining all required books and records.
High commissions, typically above 5% for variable annuities, help drive
sales of these products. Variable insurance products have higher fees and
surrender charges than mutual funds that provide no insurance features. These high fees and surrender charges combine with other
factors to make variable insurance products inappropriate for many
investors. The Commission, NASD and
other regulators have received a large number of complaints from individual
investors about variable insurance products.
Many of these complaints indicate that the customer was sold a variable
product without fully understanding the product, and express concerns that the
product was not appropriate for them, given their investment objectives.
In view of the number of complaints and the unique
characteristics of variable insurance products that require special
disclosures, controls, and procedures when selling the products, the Staff
undertook a number of examinations of broker-dealers to review sales of
variable insurance products. These
examinations reviewed: the process firms used to ensure that the product was suitable for the investor; the
supervision exercised over registered representatives selling the product;
relevant disclosure made to investors about the product; the books and records
maintained by the firm related to sales of the product; and the training
provided to firm employees about the product.
This Staff report identifies examples of both sound and weak
practices that were noted during the examinations.[1] This report is not a comprehensive roadmap
for compliance and supervision with respect to the sale of variable insurance
products, but rather points out examples of common problems that may be
encountered, and some measures that firms are using to ensure better
compliance. Firms should consider the
information in this report in assessing their own systems and procedures and in
implementing improvements that are tailored to and work best for their
firm. We note that while a particular
sound practice may work well for a large firm, the same approach may not be
effective or economically feasible for a smaller firm. The reverse is also true. Firms must adopt procedures and controls
that are effective given their size, structure and operations. Utilizing the information in this report may
be beneficial, but will not establish a safe harbor should problems or
violations arise.
In light of the findings from these examinations and recent
enforcement actions, NASD recently took steps to propose the adoption of new
rules governing the sales of deferred variable annuities. The NASD Board of Governors proposed new
requirements tailored specifically to transactions in deferred variable
annuities – from new sales practice standards and supervisory requirements to
increased disclosure and sales force training.
The new rule would codify and make mandatory best-practice guidelines
that NASD had previously issued. NASD intends to request public comment on the
proposed rule and details of the proposal will be published in a Notice to
Members. The key
requirements expected to be included in the rule proposal are described in an
NASD News Release,[2] as
summarized below.
Elements of NASD Rule Proposal
In recommending the purchase of a deferred variable
annuity, a registered representative would be required to determine that:
- the customer has been informed of the unique features of the variable annuity;
- the customer has a long-term investment objective; and
- the deferred variable annuity as a whole, and its underlying sub accounts, are suitable for the customer, particularly with regard to risk and liquidity.
The registered representative
would be required to document these determinations.
- Disclosure and Prospectus Delivery
The firm or its representative would be required to
provide the customer with a current prospectus and a separate, brief, "plain
English" risk disclosure document highlighting the main features of the
particular variable annuity transaction. Those features would include:
- liquidity issues, such as potential surrender charges and IRS penalties;
- sales charges;
- fees (including mortality and administrative fees, investment advisory fees and charges for riders or special features);
- federal tax treatment for variable annuities;
- any applicable state and local government premium taxes; and
- market risk.
The risk disclosure document would be required to
inform the customer whether a “free look” period applies to the variable
annuity contract, during which the customer could terminate the contract
without paying any surrender charges and receive a refund of his or her
purchase payments.
Before a registered
representative could effect any transaction in a deferred variable annuity, a
registered principal would be required to review and approve the
transaction. The registered principal
would be required to consider specific factors (for instance, whether the
customer’s age or liquidity needs made a long-term investment
inappropriate). Before a registered
representative could complete a recommended transaction, the registered
principal would be required to review and approve, in writing, the suitability
analysis document and a separate exchange or replacement document, if the
transaction involved an exchange or replacement of an existing variable
annuity.
The rule proposal would require registered firms to
establish and maintain specific, written supervisory procedures reasonably
designed to achieve compliance with the rule’s standards.
Registered broker-dealers would be required to develop
and document specific training policies or programs designed to ensure that
registered representatives and registered principals comply with the rule’s
requirements and that they understand the unique features of deferred variable
annuities.
II. Background: What are Variable Insurance Products?
Variable insurance products provide investment as well as
insurance features. Insurance companies
that sponsor variable products place investor monies in segregated asset
accounts called "separate accounts" and then invest the funds in the
securities markets or in an underlying fund(s). These underlying investments
are subject to market risks. Specific
features of variable products are described below.
A. Variable Annuities
A variable annuity is a contract
between an investor and an insurance company.
The company promises to make periodic payments to the contract owner or
beneficiary, starting immediately or at some future time, and should the
contract owner die during the accumulation phase, a death benefit is paid to
the beneficiary. Variable annuities
offer choices among a number of complex contract features. For example, contracts may offer various
types of death benefits, rebalancing features, dollar cost averaging options,
assorted payout structures, and optional riders such as a guaranteed minimum
income benefit, estate protection enhancements, or long-term care insurance, in
addition to a range of choices among investment options.
B. Variable Life
Insurance Products
Variable life insurance is a
permanent life insurance policy that builds cash value through the investment
of premiums into separate investment options and offers an income
tax-free death benefit to the
beneficiary. This policy is similar to
traditional life insurance, except that the investor has investment choices in
connection with the underlying assets.
The cost of insurance, as well as other fees and charges, are deducted
from the premiums prior to investment into the sub-accounts. The cash value in the sub-accounts will
depend on the performance of the underlying securities. If market values of the underlying
securities decline, additional premiums may be required to maintain current
insurance coverage, and to avoid a lapse of the policy. Variable life insurance is designed for
individuals with an actual need for life insurance coverage.
C.Death Benefit
Variable life insurance is a form of life insurance, which
pays an income tax-free death benefit to the designated beneficiary upon the
death of the insured. Variable
annuities may also provide a death benefit.
This feature is a guarantee from the insurance company that when the
owner or annuitant of the annuity dies, the insurance company will pay a
certain amount to the specified beneficiary.
The amount of the death benefit provided by a variable annuity is
typically at least the total amount invested minus any withdrawals taken, even
if the market value of the assets in the contract has declined since the
purchase. For additional fees, there
may be variations on the death benefit, such as annual or periodic “step-up”
features that cause the amount of the guaranteed death benefit to increase to
the current market value of the assets in the variable annuity at the
designated point in time each quarter, year, or specified number of years.
D. Annuitization
Variable annuity contracts provide for a series of payments
to be made to a person named as the annuitant on the contract. Payments can begin immediately or after a
certain period of time. There are
various payment options, one of which usually includes a monthly payment from
the insurance company for as long as the annuitant lives.
E.Fees
Variable products may have a variety of fees. Annual fees based on the value of the
contract can be substantial. Average
annual expenses of a variable annuity have been estimated by various sources to
be in a range from 1.3% to 2.2% of the underlying assets in the account. [3] SmartMoney.com
(citing Morningstar) recently compared the average annual expense charge on
variable annuity subaccounts with those in mutual funds. The article stated that the average annual
expense charge on variable annuity subaccounts has been increasing, and is
currently 2.3% of assets, including fund expenses and insurance expenses. The average mutual fund, in contrast,
charges 1.44%.[4]
Fees may include:
- Surrender charges, which are incurred if the owner withdraws money from the annuity before a specified period (often seven to nine years). Surrender charges usually start at around 6-8% of the amount invested and decline gradually to zero over a period of several years;
- Charges for riders or special features, such as an enhanced death benefit or a guaranteed minimum income benefit;
- Mortality and expense risk charges, which the insurance company charges for the insurance risk it takes under the contract;
- Front end and back end loads, which are charged by the insurance company sponsor;
- Administrative fees, for record keeping and other administrative expenses;
- Advisory fees, paid to the investment advisers who manage the underlying funds;
- Distribution fees, including 12b-1 fees, paid by the fund to the broker-dealer to reimburse costs of distribution; and
- Other underlying fund expenses relating to the investment options.
F. Tax Treatment
One benefit of
variable insurance products is favorable tax treatment under the Internal
Revenue Code (“IRC”). Investors should
consult their tax advisors to fully understand these potential benefits.
Purchasers of
variable insurance products can direct their premiums to various underlying
investment portfolios (generally investment companies or funds) established in
the separate accounts, which in turn invest in the stock market. The tax-deferral feature enables investors
to transfer money between investment options available under the contract
without incurring a tax liability at the time of transfer. Earnings in both variable annuities and
variable life products accumulate on a tax-deferred basis.
While variable products provide
tax-deferral features, the insurance company issuer may limit early
withdrawals, and withdrawals may have adverse tax consequences. The IRC requires (in most cases) that earnings
withdrawn from a variable annuity contract before the customer reaches 59-1/2
be subject to a 10 percent penalty.
Limitations that apply to variable annuities differ from those
applicable to contributions to certain retirement accounts, such as Individual
Retirement Accounts (“IRA”) or 401(k) accounts.
Death benefits on variable life insurance policies generally
are received by the beneficiary income tax-free. However, variable annuity earnings are subject to ordinary income
taxes, not capital gains rates (which may be lower) when they are paid
out. Upon inheritance, a beneficiary
will pay taxes at ordinary income rates on the earnings of a variable
annuity. In comparison, assets such as
stock would be inherited at the stepped-up basis as of the date of death of the
owner. As a result, the beneficiary
would pay lower taxes on earnings upon the sale of stock as compared to the
sale of a variable annuity. Both types
of assets are subject to inheritance taxes.
III. Examination Findings
A. Suitability,
Sales Practices, and Conflicts of Interests
A broker-dealer recommending a variable product to an
investor must assess the investor’s financial status, investment objectives,
and other relevant information to determine if the product is suitable. The obligation to recommend only securities
that are suitable for the customer arises from the antifraud provisions of the
federal securities laws, and from rules of the self-regulatory organizations
(“SROs”). A broker-dealer, by hanging
out its “shingle” and conducting a public securities business, impliedly
represents that it will deal fairly with customers.[5] As part of this obligation of fair dealing,
broker-dealers must have a reasonable basis for believing that their securities
recommendations are suitable for the customer in light of the customer’s
financial needs, objectives and circumstances.
In addition, broker-dealers must have a reasonable basis for believing
that the particular security being recommended is appropriate. Under NASD Rule 2310 and IM 2310-2, when a
broker-dealer recommends a security to a customer, it must determine that the
security is suitable for that customer in light of that customer’s particular
age, financial situation, risk tolerance, and investment objectives. Because variable annuities and variable life
insurance are complex products, the NASD has issued additional guidance in
assessing the suitability of recommendations of variable products in Notices to
Members (“NTM”) 96-86, 99-35, and 00-44.
In addition to existing securities laws and rules governing
suitability, the National Association of Insurance Commissioners (“NAIC”) has
expressed concern regarding the sale of variable annuities to seniors. As a result of these concerns, on September
14, 2003 the NAIC adopted a Model Regulation entitled Senior Protection in
Annuity Transactions. The model
regulation, which was adopted as a model for state legislation, requires
insurers and producers to use standards similar to those required by the NASD
for variable products to evaluate the suitability of recommendations.
Described below are examples of both weak and sound
practices identified by examiners relating to firms’ suitability practices.
- Weak practices noted
- Unsuitable variable product recommendations were made without a reasonable basis in light of information the broker may have had regarding the customer's:
- Age
- Financial or tax status (e.g., sales that exceed a pre-
determined percentage of the customer's net worth; sales
that require the mortgage of a home to finance the purchase;
sales that require a customer to borrow from an existing life
insurance policy or annuity; or sales to a corporation, trust,
or other non-natural entity that did not hold as agent for a
natural person, and whose purchase therefore caused the loss of tax-deferral status in the annuity);
- Investment objectives (e.g., same product recommended to
all customers (one size fits all), or a customer's current need
for income);
- Investment sophistication and ability to understand the
complexity of variable products generally, and to monitor
the investment of the separate account;
- Low risk tolerance (e.g., high risk equity funds are
recommended to an investor with low risk tolerance);
- Need for liquidity (e.g., sale of an illiquid variable product to
persons who need their funds soon, and as a result incur
surrender charges to obtain their funds);
- Lack of need or desire for life insurance;
- Ineligibility under the terms of the prospectus; and
- Other relevant information, such as investments made for
college planning, despite the fact that the owner-parent
would not reach age 59-1/2 before the child would begin
college (surrender charges and tax penalties associated
with withdrawal from a variable annuity may make the
product prohibitively expensive for such a purpose).
- Unsuitable switching or replacement:
- Registered representatives gave unfounded, false or
misleading justifications for switches or replacements;
- Registered representatives misrepresented or failed to inform
clients of sales charges associated with switches or
replacements; and
- Excessive switching of variable annuities took place in
customer accounts, often on a periodic basis, once every 2-3
years.
- Inadequate policies and procedures:
- Guidance was not provided to registered representatives
regarding the factors to consider in determining the
suitability of variable products or underlying funds;
- Procedures and controls did not require that a registered
representative collect all information required to conduct a
suitability analysis;
- Procedures did not require that the suitability analysis be
documented;
- Procedures and controls did not detect and prevent excessive
switching and other abusive sales practices; and
- Firms did not have controls in place to protect against
abusive practices related to conflicts of interests.
- Inadequate supervisory reviews:
- Correspondence, including e-mails and instant messaging,
was not reviewed closely enough by a principal to identify
unfounded, false, or misleading justifications for switches or
replacements;
- Firms did not require supervisors to review the suitability of
recommendations or sales; and
- Firms did not utilize compliance systems, such as computer-
generated exception reports, to identify patterns of
abusive sales practices by their registered representatives.
(See Appendix A for examples of such exception reports.)
- Sound Practices
- Practices to foster suitable investments:
- Firms required registered representatives to document each sale with a suitability checklist that evidenced the suitability determination;
- Firms assessed and made recommendations based on the
liquidity needs of their customers; those with short-term
investment objectives were advised that variable annuities
were not suitable because they are long-term investments;
- If an investment did not seem to meet the customer's needs
and objectives (e.g., if the investments in variable products
totaled more than a certain percentage of the customer's net worth, or the investment objectives did not fit with the
choice of a variable product), firms contacted the customer
for current information, assessed suitability based on
that information, and advised the customer not to purchase the product where it appeared unsuitable;
- Firms implemented controls to prevent their registered representatives from inappropriately recommending that a customer mortgage their home for the purchase of variable annuities or variable life insurance; and
- Suitability determinations were made at two levels: the
contract level and the underlying fund level.
- Selection and review of investment advisers:
- In selecting or recommending an investment adviser for
asset allocation within the variable annuity, or for wrap and
managed account programs to purchase and hold variable
annuities, the firm and registered representative had a
reasonable basis for the recommendation, based on due
diligence done on the investment adviser;
- Regular reviews were conducted to evaluate advisers and
terminate contracts with those that no longer met firm
standards;
- Only variable annuities with reduced advisory fees, designed
especially for wrap accounts, were offered to investors
purchasing within wrap accounts. Investors received
periodic investment advice regarding the allocation of assets
within the wrap account, including allocations among
underlying funds of the variable annuity held in the wrap
account; and
- Reports were generated comparing asset-based fees charged
in a brokerage account to commissions that would have been
generated in the same account over the same time period, and these reports were considered as part of a periodic review of the appropriateness of such fee-based accounts. (Note: When variable products are held in fee-based accounts, the customer may be charged more than if the same products were held in commission-based accounts. The additional expense is unnecessary unless the customer receives an additional benefit, such as investment advice.)
- Comprehensive policies and procedures:
- Firms implemented written suitability guidelines specifically
for variable products, and guidelines addressed the steps
necessary to obtain the required customer information;
- Firms provided written guidance to registered
representatives regarding their analysis of the customer's
financial situation and objectives, review of the product's
features with the customer, discussion of key issues with
the customer, providing an adequate trail of documentation,
and performing a comprehensive supervisory review;
- Firms implemented procedures to screen for specific
suitability issues, including age, allocations that did not
match investment objectives, variable product investments
exceeding a certain percentage of the customer's liquid net
worth, more than a specified dollar amount invested in a
variable annuity, the purchase of a variable annuity for
college tuition payments when the owner's age would cause
planned distributions to be taxable, and variable life
financing;
- Firms implemented procedures to prevent unsuitable
sales of variable annuities in an IRA, 401(k), or other tax-
qualified accounts;
- Firms' procedures provided suitability screening before
transactions took place;
- Firms implemented procedures requiring the use of specified
formulae for analysis of accounts, which helped them to
avoid excessive switching in customer accounts. Firms
identified exchange transactions that occurred within a
certain period of time after the prior purchase, and
analyzed the costs of surrendering any prior product,
compared to the benefits of investing in a new product, on a
careful, mathematical basis; and
- Firms implemented effective procedures to identify, assess,
monitor and control conflicts of interests.
- Review of communications:
- E-mails, instant messaging and other correspondence were
promptly reviewed by a principal, with a view to identifying unfounded, false, or misleading representations.
- Systems:
- An automated system was implemented to facilitate a
comparison of sales recommendations with the client's
suitability profile to assure that sales were consistent with
the client's investment objectives and risk tolerance, down
to the underlying fund level;
- An electronic order system was implemented to reject new
orders if the client's suitability profile was not complete and
up-to-date; and
- Exception reports were generated to flag sales of variable
products that raised concerns and these reports were used for
supervisory purposes. (See Appendix A for examples of
exception reports.)
B. Supervision
Section 15(b)(4)(E) of the Exchange Act authorizes the
Commission to censure or revoke the registration of any broker-dealer that has
failed to supervise another person who commits a violation of the federal securities
laws, rules, or regulations. Section
15(b)(6)(A) of the Exchange Act authorizes the Commission to censure, suspend,
or bar from association with a broker or dealer, a person who has been
convicted of an offense or otherwise violated certain rules, as specified in
the statute. NASD Rule 3010(a) and NYSE
Rule 342 require broker-dealers to supervise their employees in a way that is
reasonably designed to achieve compliance with the securities laws, rules, and
regulations. NASD Rule 3010(b) also requires
broker-dealers to establish, maintain, and enforce written procedures to
supervise the type of business in which the firm is engaged. A broker-dealer must obtain information
about and supervise the activities of registered representatives who receive
selling compensation for activities as set forth in NASD Rule 3040.
- Weak practices noted
- Inadequate written supervisory procedures:
- Procedures did not adequately address the firm's
variable product business;
- Common problems included:
- no requirement to ascertain customer objectives;
- no requirement to determine whether the product is
suitable;
- no requirement to review allocation of premium
payments to the underlying funds; and
- no procedures for remedial measures for problem
registered representatives.
- Procedures were not updated to address the firm's growing variable product business; and
- Procedures did not adequately provide for the identification
of customer correspondence as complaints.
- Supervisory failures:
- Supervisors failed to review transactions;
- Supervisors failed to approve transactions;
- Supervisors did not investigate red flags adequately (e.g.,
when a pattern of excessive switching was identified, the
supervisor relied on information provided by the registered
representative, rather than obtaining other, objective
information; and when a registered representative said that
he switched products to lock in a higher death benefit, the
supervisor failed to ask if the customer was concerned about
assets for himself or his heirs);
- Firms failed to put registered representative on heightened
supervision after indications of abusive sales practices or
other problems were identified; and
- Firms did not identify and prevent manipulative and abusive
sales practices, or fraudulent and unsuitable sales to
market timers, hedge funds, and other customers.
- Documentation failures:
- Evidence of supervisory review and approval, such as a
principal's signature, was missing from New Account
forms, order tickets, and other documents that require
a record of supervisory approval; and
- Firms' account documents did not include customers'
net income, net worth (exclusive of primary residence) or
investment objectives and other information, which could
have been used by the broker-dealer to make a suitability
determination.
- Systems failures:
- Firms did not employ systems to assure their written
supervisory procedures were enforced;
- Firms did not monitor variable product sales activities of
their registered representatives, through exception reports or
otherwise, thereby limiting their ability to supervise; and
- Firms did not use reports and services from insurance
company issuers of variable products or clearing firms that
would assist in supervision.
- Sound Practices
- Comprehensive written supervisory procedures:
- Procedures were updated to keep pace with the firm's developing businesses, as well as changes in the law, new
rules, and NASD NTMs;
- Procedures included:
- detailed description of responsibilities of registered principals and other supervisors, including for reviewing transactions for
suitability, verification of customer information,
and approval of transactions;
- guidelines describing when recommendations require scrutiny, such as sales to individuals over a particular age, customers requiring immediate income or access to funds, customers desiring guarantees against loss of their principal, or sales of variable products in amounts that exceed a pre-determined percentage of net worth;
- guidelines requiring that when certain
parameters were present (including when the
customer was over a specified age, when the
transaction would take place in a tax-qualified
account, and when the transaction was a switch
where the previous product had been held less
than a specified time period), the firm would
require pre-approval of the transaction by a
centralized second-tier review unit;
- information registered representatives must consider in conducting a suitability analysis
regarding the features of variable products, including tax consequences, types and general
ranges of fees, insurance aspects (e.g., death benefits, living benefits, potential lapse of
coverage, etc.);
- a comprehensive list of documents registered representatives must use in the sale of variable products;
- guidelines describing how the required documents were to be used and which documents were required with each sale;
- methods to objectively analyze the benefits of a variable product over alternative investments (e.g., cost analysis, unique product features),
and specific standards or guidelines to be
followed regarding when it is appropriate to
recommend the initial sale of a variable
product, the exchange of a product, and the
purchase or the sale of a variable annuity
within an IRA, 401(k), or other tax-qualified
account;
- steps for the timing of document completion (before the sale, after the sale, etc.); and
- guidelines indicating when the supervisor or the firm would contact a customer to verify that the recommendation was suitable.
- Supervision:
- Supervisors reviewed every sale of a variable product to ensure that it was appropriate;
- When indications of abusive sales practices or violations
were identified, firms quickly investigated the issue and
took appropriate action (e.g., putting employees on
heightened supervision, suspending, fining or terminating
them), and also determined whether supervisors reasonably
carried out their responsibilities;
- Firms reviewed their supervisory systems and procedures to
determine whether an identified weakness, deficiency, or
apparent violation was indicative of a defect in the firm's
system of supervision or its written supervisory procedures;
- Supervisors reviewed the allocation of premium payments to
the underlying funds;
- Supervisors reviewed hypothetical illustrations to ensure assumed rates of return (e.g., 6%, 12%) were indicative of
current markets and reflective of appropriate assumptions;
- A centralized second-tier review unit was established at
headquarters to review suitability of all variable insurance
product transactions and to reject inappropriate transactions,
including analyzing activity and providing reports to
branch managers on replacement and exchange activity;
- Complaints were responded to timely and appropriately,
were actively monitored, and were sorted by product and
problem types, as well as by branch and registered
representative, to facilitate reviews; and
- Comprehensive reports were produced on a periodic basis,
which analyzed trends in complaints received.
- Systems:
- Automated systems were implemented to detect and prevent
improper and excessive financed and replacement sales of
variable life insurance products;
- Exception reports were comprehensive and tailored to
identify potential problems involving sales of
variable products (see Appendix A for examples); and
- Introducing firms and clearing firms worked together to
create effective reports, and reports from insurance issuers
were used to gather complete information, to identify
problems.
C. Disclosure
Broker-dealers selling variable products to customers must
act in accordance with the just and equitable principles of trade provided by
NASD rules. Moreover, they have general
agency duties. For example, they have
an obligation to disclose to customers any material conflict of interests. Failure to disclose material conflicts may
constitute a violation of the general antifraud provisions of the federal
securities laws under Section 17(a) of the Securities Act of 1933 (“Securities
Act”) and Section 10(b) of the Exchange Act of 1934 (“Exchange Act”).
A
broker-dealer is required to deliver a prospectus on or before the transaction
settlement date (Section 5(b)(2) of the Securities Act). Antifraud provisions of the federal
securities laws prohibit making misrepresentations or omissions of material
facts in the purchase, offer or sale of securities (Section 17(a) of the
Securities Act and Section 10(b) of the Exchange Act, as well as Rule 10b-5
under the Exchange Act). Broker-dealers
are required to maintain documentation of any written disclosure made to
customers (Rule 17a-4(b)(4) under the Exchange Act).[7]
The NASD has provided guidance to
broker-dealers regarding disclosures that broker-dealers should make to
customers investing in variable insurance products.[8] This guidance states that to the extent
practical, registered representatives should provide a current prospectus to
customers when recommending a variable life insurance policy or variable
annuity contract. Registered
representatives should be available to discuss the information that is
contained in the prospectus. Firms may
also wish to provide customers with firm-approved product information brochures
that explain the features and principal risks associated with variable life
insurance. Registered representatives
should discuss with the customer all relevant facts such as fees and expenses
(including mortality and expense charges, administrative charges, and
investment advisory fees); the lack of liquidity of these products, (including
issues such as potential surrender charges and the federal tax penalty); any
applicable state and local government premium taxes; and market risk. The NASD suggests that the registered
representative should make sure that the customer understands the effect of
surrender charges on redemptions and that a withdrawal prior to the age of
59-1/2 could result in a withdrawal tax penalty, and should also make sure that
customers who are 59-1/2 or older are informed when surrender charges apply to
withdrawals. Moreover, the NASD
suggests that any communication discussing the tax-deferral benefits of
variable life insurance should not mislead the investor by obscuring or
diminishing the importance of the life insurance features of the product, or by
overemphasizing the investment aspects of the policy or potential performance
of the subaccounts. With regard to
sales of annuities in tax-qualified plans, the NASD states that when a registered
representative recommends the purchase of a variable annuity for any
tax-qualified retirement account (e.g.,
401(k) plan, IRA), the registered representative should disclose to the
customer that the tax-deferred accrual feature is provided by the tax-qualified
retirement plan and that the tax-deferred accrual feature of the variable
annuity is unnecessary.
NASD suggests that the member firm may decide to develop an
exchange or replacement analysis document or utilize an existing form
authorized by a state insurance commission or other regulatory agency for
variable product replacement sales. If
such a document is used, then (consistent with the requirements of various
states) the appropriate form should be completed for all variable annuity and
variable life insurance replacements, and it should include an explanation of
the benefits of replacing one contract or policy with another. The customer, the registered representative,
and the registered principal should sign the document.
Finally, when financing is recommended, the NASD recommends
that registered representatives should disclose to the life insurance policy
owner the potential consequences to both the existing and new policy. Members should provide a form to the
registered representative that documents the customer’s informed consent to the
financing. The form should include the
customer’s acknowledgement, the registered representative’s signature, and a
registered principal’s signature. (NASD
NTM 00-44).
Under NASD Rule 2110, it is unethical conduct to circumvent
any state law or other SRO regulations related to exchange transactions,
including disclosure requirements such as N.Y.S. Insurance Code Regulation
60.
In some cases, the broker-dealer may also be a registered
investment adviser, or may be acting as a solicitor for an investment
adviser. These activities may impose a
duty to disclose receipt of special compensation or compensation from third
parties. Additional disclosure issues
arise with respect to the sale of variable annuity products in wrap accounts
and managed accounts. (See Investment Advisers Act of 1940
(“Advisers Act”) Section 206. See also Rule 206(4)-3 under the
Advisers Act, and NASD NTM 03-68).
- Weak practices noted
- Firms failed to disclose:
- Fees:
- the nature of the product and the fact that it bears
additional costs and expenses associated with its
insurance features, such as Mortality and Expense
(M&E) charges, cost of insurance (COI) charges, and administrative fees; and
- the amount of any advisory, management, or wrap fees,
whether they are included within the structure of the
variable product or are charged to the account.
- Risks:
- potential market losses due to market declines;
- investment decisions;
- interest rates in fixed account; and
- issuer financial strength risk.
- Lack of liquidity of variable products:
- the amount of surrender charges and length of
surrender period, both in the initial purchase of a
variable product and in the exchange of an existing
variable product (particularly when a bonus
product is being sold as a replacement).
- Guaranteed death benefit:
- the fact that a "guaranteed death benefit" of a variable
product accrues to the beneficiaries only upon the
death of the annuitant or insured.
- Tax implications:
- tax disadvantages of a variable annuity, such as tax on
any increase in value at ordinary income rates upon
distribution, and inclusion of the entire value of the
annuity in calculation of the estate tax;
- estate tax consequences of naming the insured as the
owner of a variable life policy;
- lack of additional tax benefit when purchasing a
variable annuity in an IRA, 401(k), or other
tax-qualified account; and
- tax treatment of withdrawals and loans should a policy
become a Modified Endowment Contract (MEC).
- Potential consequences of financing a variable product:
- the fact that borrowing against cash value in an
existing life policy or annuity will deplete the cash
value;
- the fact that the new policy will lapse if premiums
cannot be paid;
- the interest rate risk associated with any variable rate
loan; and
- that investment returns may not be sufficient to pay
mortgage payments if home equity is used to finance
the purchase of a variable product.
- Undisclosed conflicts of interests:
- Investment advisers were recommended for asset allocation
services within variable annuities in conjunction with wrap
or managed accounts programs, based on affiliation with
or expected payments to the broker-dealer, rather than on the
adviser's ability to assist the investor.
- Inadequate disclosure procedures and controls:
- controls did not require registered representatives to provide full, clear, and balanced disclosure to customers, including features, benefits, fees (including double layer of advisory fees for wrap and managed accounts), length of surrender periods, amount of surrender charges, and other information, presented in plain English.
- Sound Practices
- Specific disclosures were made about:
- Fees:
- full and balanced disclosure of the features, benefits,
fees, charges, and surrender period of the recommended variable product;
- comparison of the features, benefits, fees, charges, and
surrender periods of the old and new products in an
exchange transaction; and
- the need to maintain sufficient cash or other liquid
assets in a managed account to cover management or
wrap fees, so the investor will not incur unnecessary
surrender charges and tax penalties for fees that were
foreseeable at the time the product was sold.
- Risks:
- potential market losses due to market declines;
- investment decisions;
- interest rates in fixed account; and
- issuer financial strength risk.
- Tax implications:
- disclosure in connection with sales within qualified
accounts, i.e., that the tax-deferral feature may be
redundant and that there must be a good reason (other
than tax-deferral) for recommending the purchase.
- Procedures and controls:
- Firms required their registered representatives to provide the
prospectus for the variable product (and where possible, for
any underlying funds that were recommended) at the point
of sale and required a prospectus delivery receipt signed by
the client (even though prospectus delivery is legally
required only at settlement of the transaction);
- Procedures provided a description of how the disclosures
were to be made and what evidence was required, such as a
prospectus receipt signed by the customer;
- Forms were provided for disclosure purposes and the
information required on those forms was detailed in plain
English;
- Firms informed their registered representatives that if no
documentation of disclosure to or of a conversation with a
client exists, the firm assumes that the disclosure was never
provided, or the conversation never occurred;
- Customers were referred to information about investing in
variable products and investing risks on the SEC and
NASD websites or were given these materials; and
- Firms used a disclosure and comparison form to disclose
to customers in full, clear, and balanced terms the features,
benefits, fees, risks, surrender periods, and financing risks of
variable product transactions.
D. Books and Records
Broker-dealers are required
to make and keep certain records (Rules 17a-3 and 17a-4 of the Exchange
Act). These rules were recently amended
to require, among other things, that broker-dealers obtain updated information
about their customers’ investment objectives on a periodic basis, and that they
maintain or make available certain information at branch offices (see Books and Records Requirements for
Brokers and Dealers Under the Securities Exchange Act of 1934, Exchange Act
Release No. 34-44992 (October 26, 2001) and Final Rule Correction Exchange Act
Release No. 34-44992A (March 26, 2003)).
The Commission also recently issued an Interpretive Release regarding
these rules that describes, among other things, the application of the daily
blotter requirement to variable product transactions (Exchange Act Release No.
34-47910 (May 22, 2003), 68 FR 32307 (May 29, 2003) at http://www.sec.gov/rules/interp/34-47910.htm). A broker-dealer may also be required to
create or maintain additional records pursuant to the rules of the SROs (e.g., NASD Rules 3110 and 2310). Among other things, a broker-dealer
effecting transactions in variable products must create and maintain a purchase
and sales blotter, order tickets, and customer account information.
- Weak practices noted
- Customer information:
- Customer information was not obtained or maintained as
required, with the result that the suitability of
recommendations could not be determined, and adequate
supervision could not be performed.
- Suitability:
- Documentation supporting recommendations of variable
products to customers was not maintained; and
- Exchange or replacement analysis documents did not
include an explanation of the benefits of replacing one
contract or policy with another, did not request the
customer's reason for the replacement, or did not require the
customer's signature.
- Disclosure:
- Little or no documentation was maintained of disclosure to
customers of variable products' fees, risks and expenses.
- Written supervisory procedures:
- Firms failed to prepare or maintain documents or forms that
were called for in their internal procedures.
- Complete daily blotter:
- Purchases and sales of variable insurance products were not
captured in the daily blotter.
- Complete orders:
- Order information was not captured on order tickets, or order
tickets were not created and maintained.
- Customer complaints:
- Customer complaints were not reported to the NASD as
required;
- Customer complaints were not always analyzed, researched,
and acted upon in a timely manner.
- Sound practices
- Customer information:
- A new account form was obtained and maintained on file for
each customer, along with application or order forms for each
transaction; and
- Updated client information was obtained on a regular basis.
- Suitability:
- Firms were able to evidence their suitability determinations and reviews because they maintained customer information used to support each recommendation, including purchases of variable annuities in an IRA, 401(k), or other tax-qualified account; and
- Forms used to document the customer's reason for switching required that the reasons be written out and signed by the customer, rather than simply providing a checklist for the customer to choose from.
- Disclosure:
- Full and complete documentation of written disclosures made
to the customer was maintained.
- Daily blotter:
- Transaction information was maintained for all purchase
and sale transactions in all variable products, including both
sides of exchange transactions.
- Orders:
- Information regarding all orders, whether executed or
unexecuted, including orders that were withdrawn, cancelled,
or rejected, was created and maintained.
- Customer complaints:
- Customer complaints were reported appropriately to the
NASD or other SRO; and
- Customer complaints were analyzed, researched,
and acted upon in a timely manner.
E. Training
Examiners found that many
deficiencies resulted from inadequate or inappropriate[9]
training of firm employees. Given the
complexity of the product, it is critical that broker-dealers ensure that their
registered representatives and supervisors have adequate training to carry out
their responsibilities regarding the sale of variable products.
- Weak practices noted
- Inadequate coverage of training program:
· Training programs did not address the sale or supervision of
variable products;
· Firms provided general training to registered representatives
that did not cover special features of variable annuities or
specific suitability issues;
· The supervisor reviewing variable transactions was not
sufficiently trained or experienced to identify abusive sales
practices; and
· Annual compliance meetings and "firm element" continuing
education programs did not include information on the sale of
variable products.
- Sound Practices
- Comprehensive training:
- The training program effectively addressed the sale of
variable products, to ensure that all registered representatives
were adequately trained to carry out their responsibilities
regarding the sale of variable products;
- Training covered who was responsible for conducting the
suitability analysis, a description of how this was to be done,
when it would be done, and how it would be evidenced;
- Firms provided special training for supervisors to enable
them to oversee variable product sales and identify
problems; and
- Firms provided regular periodic training on variable products
and the firm's procedures with regard to their sale.
- Supervision of training:
- There were appropriate measures for supervision of
registered representatives' attendance at sales training
seminars;
- Broker-dealers carefully reviewed proposed external
training seminars so they were comfortable that the content
would not encourage inappropriate or unethical behavior;
and
- If firms were concerned about external seminars their
representative may have attended, special attention was
given to the review and approval of those representatives'
transactions following the training.
IV. Recent Enforcement Cases
The SEC and NASD have
recently brought a number of enforcement actions involving the sale of variable
annuities. These actions involved
excessive switching, misleading marketing, failure to disclose material facts,
unsuitable sales, inadequate written supervisory procedures, failure to
maintain adequate documentation, and/or failure to supervise variable product
transactions. A summary describing
recent enforcement cases brought by the SEC and the Commission is available on
the NASD website at http://www.nasdr.com/white_paper_0600804_apen.asp.
V. Conclusions
As the Report on the Joint
Regulatory Sales Practice Sweep observed, “[t]he protection of customers
from sales practice abuses or other financial harm is critical to maintaining a
healthy securities industry.” [10] Examinations conducted by the SEC and NASD
indicate that firms can take steps to improve their compliance and supervisory
practices in selling variable products.
Examples of sound practices and weak practices are described in this
report. The Staff of the Commission and
NASD urge firms to consider the sound practices summarized in this report and
improve their supervisory procedures and compliance systems as appropriate to
more effectively reduce potential harm to the investing public.
APPENDIX A
Examples of
Relevant Exception Reports
Examples of exception reports that may be useful in
identifying abusive sales practices and violations in the sale of variable
insurance products include:
- Client’s age over firm’s internal maximum;
- Clients with low net worth;
- Clients with low annual income;
- Clients in the lowest tax bracket;
- Clients
with limited investment experience;
- Clients with high net worth (VA’s may not be
appropriate for extremely high net worth individuals);
- Clients
whose variable annuity purchases exceed a specified percentage of their net
worth;
- Clients whose assets are heavily concentrated in VIPs;
- Representatives with a large number of elderly clients
of modest means, or with limited investment experience;
- Sales to
accounts of non-natural persons (trusts, corporations);
- Comparison of investment choices to customer’s
investment objectives;
- Variable annuities in an IRA, 401(k), or other
tax-qualified accounts;
- Variable annuities in wrap accounts;
- Free look cancellations;
- Surrenders;
- Charge
backs;
- Replacements
with large surrender charges;
- Surrender charge and other costs of exchange exceed
bonus and other benefits received;
- Transactions where surrender took place shortly before
a lower surrender charge would have taken effect;
- Underlying
fund transactions for market timing activity and late trading activities;
- Short holding period (one to five years);
- Registered representatives with a high percentage of
replacements and 1035 exchanges;
- Representatives
who repeatedly switched clients after comparatively short holding periods;
- Lapses in
variable life insurance for non-payment of premiums;
- Variable
life insurance sales with premium payments exceeding a certain percentage of
annual income;
- Loans from
variable life policies; and
- New
variable life policies were matched with disbursements from existing life
insurance policies or annuities to track that activity.
Appendix B
References and Resources
Compensation:
NASD Conduct Rule 2820
Suitability:
Securities Act of 1933, Section 17(a)
Securities Exchange Act of 1934, Section 10(b)
Securities Exchange Act of 1934, Rule 10b-5
NASD Conduct Rule 2310
NASD IM-2310-2
NASD Notice to Members 96-86
NASD Notice to Members 99-35
NASD Notice to Members 00-44
NASD Notice to Members 03-68
Supervision:
Securities Exchange Act of 1934, Rule 15(b)(4)(E)
NASD Conduct Rule 3010
NASD Conduct Rule 3040
NASD Notice to Members 99-45
NASD Notice to Members 03-49
Disclosure:
Securities Act of 1933, Section 5(b)(2)
Exchange Act Release No. 34-49148 (January 29,
2004) at
http://www.sec.gov/rules/proposed/33-8358.htm
NASD Conduct Rule 2210(d)
NASD Notice to Members 99-35
NASD Notice to Members 00-44
NASD Notice to Members 03-68
Books and
Records:
Securities Exchange Act of 1934, Section 17(a)
Securities Exchange Act of 1934, Rules 17a-3 and
17a-4
Exchange Act Release No. 44992
(October 26, 2001), 66 FR 55818 (Nov. 23, 2001), at http://www.sec.gov/rules/final/34-44992.htm
Exchange Act Release No. 47910
(May 22, 2003), 68 FR 32307 (May 29, 2003), at
http://www.sec.gov/rules/interp/34-47910.htm
NASD Conduct Rule 3110
NASD Conduct Rule 2310
Referral
Payments:
Investment Advisers Act of 1940
Section 206
Investment Advisers Act Rule
206-4(3)
SEC No Action Letter re: First of
America Brokerage Services, Inc. (Sept. 28, 1995)
Investor
Education Materials:
Variable
Annuities and Variable Life Products: Questions to Ask
at
http://www.sec.gov/investor/pubs/varaquestions.htm
Variable Annuities: What You Should Know
at http://www.sec.gov/investor/pubs/varannty.htm
NASD Investor Alert, Beyond the Hard Sell
at
http://www.nasd.com/Investor/Alerts/alert_variable_annuities.htm
NASD Investor Alert, Should You Exchange Your
Variable Annuity?
at
http://www.nasd.com/Investor/Alerts/alert_annuityexchanges.htm
NASD Investor Alert, Should You Exchange Your Life
Insurance Policy?
at
http://www.nasd.com/Investor/Alerts/alert_exchange_lifeinsurance.htm
NASD, Equity Indexed Annuities – A Complex Choice
at
http://www.nasd.com/Investor/alerts/indexed_annuities.htm
NASD, Investing in a 401(k) – an Investment Menu
at http://www.nasd.com/Investor/Smart/401k/investing
401k/inv1_1j.html
NASD Investor Alert, Betting the Ranch: Risking Your Home to Buy Securities
at http://www.nasd.com/Investor/Alerts/alert_betting_ranch.htm
For additional information, contact:
Office of Interpretations and
Guidance
Division of Market Regulation
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
(202) 942-0069
E-mail address: marketreg@sec.gov
Or
NASD
Gateway Call Center
1390 Pickard Drive
Rockville, MD 20850
(301) 590-6500
World Wide Web site: www.nasd.com
* * * *
[1] This report represents the
findings and views of the Staff of the Commission and NASD, and not the
Commission itself. For purposes of this
report, Staff of the Commission and NASD are collectively referred to as
“Staff.” In this report, “weak
practices” are those which reflect a lack of robust controls to prevent
violations of the federal securities laws or Self Regulatory Organization rules
and “sound practices” reflect robust controls to help prevent such
violations. In some instances, a weak
practice may itself constitute a violation.
[2] NASD proposes specific requirements for deferred variable annuity sales (April 26, 2004), at http://www.nasdr.com/news/pr2004/release_04_027.html.
[3] See Andrea Coombes, Perfect tool – For a select few: Variable
annuities have limited use, Schwab study finds, CBS MarketWatch.com (Nov.
8, 2002) at http://cbs.marketwatch.com/news/story.asp?guid=%7BD2491D4F%2D2437%2D4B24%2DB2B9%2D7632D632843F%7D&siteid=mktw. See
also John P. Huggard, J.D., C.F.P.,
Investing With Variable Annuities
§703, p. 27 (2002).
[4] What’s Wrong With Variable Annuities? SmartMoney.com (2004) at http://www.smartmoney.com/retirement/investing/index.cfm?story=wrongannuities.
[5] See 1963 Special Study of the Securities Markets, H.R. Doc. 95, 88th
Cong., 1st Sess. (1963) (the “Special Study of the Securities
Markets”) at 238; see also Richard
N. Cea, 44 S.E.C. 8, 18 (1969), and Mac Robbins & Co., 41 S.E.C.
116 (1962). In addition, in 1994 the
Commission stated that suitability should be considered as a facet of the
shingle theory and is part of the obligation every broker-dealer owes to every
customer. Investment Advisers Act
Release No. 1406 (March 16, 1994), 59 Fed. Reg. 13464, 13465 n. 6 (March 22,
1994).
[6] Exception reports include
reports that identify exceptional numerical occurrences, such as frequent
trading in customer accounts, unusually high commissions, or an unusually high
number of trade corrections or cancelled transactions. These reports help supervisors, compliance
officers, and securities regulators to discover sales practice problems such as
excessive switching, unauthorized trading, and other indications of securities
fraud.
[7] In addition, the SEC has
proposed a new point-of-sale disclosure rule, Proposed Rule 15c2-3 under the
Exchange Act, which would require additional disclosure, beyond that currently
required, of material information regarding unit investment trusts (including
variable annuities) prior to the transaction.
The proposed new point-of-sale disclosure rule would require
broker-dealers to provide point-of-sale disclosure to customers about costs and
conflicts of interests. See Confirmation Requirements and Point
of Sale Disclosure Requirements, Securities Act Release 33-8358 (January 29,
2004) at http://www.sec.gov/rules/proposed/33-8358.htm.
[8] See NASD NTMs 96-86, 99-35, and 00-44.
[9] The Staff of the SEC and
NASD are reviewing the participation of registered representatives in sales
training seminars designed to teach aggressive techniques for selling variable
products to the elderly. The State of
Massachusetts recently issued an Elder Alert alerting investors to potential
fraud in investment seminars. Earlier,
on September 25, 2002, the state brought an administrative action, In the
Matter of Tyrone M. Clark, Brokers Choice of America, Senior Benefit Centers
Network, Mass. Securities Div., Adm. Complaint #E 2002-47, alleging that
the respondents recruited and trained individuals to act as its unregistered
investment adviser representatives, specifically to target the elderly and to
coerce them into selling their securities holdings to purchase annuities,
paying exorbitant commissions. The
complaint alleges that respondents utilized “Senior Financial Survival
Workshops” as part of an unethical and dishonest scheme to deceive, coerce, and
frighten the elderly into purchasing annuities through Brokers Choice of
America. The Staff of the SEC and NASD
are concerned that, if these allegations are true, some of these training firms
may be aiding and abetting the fraudulent sale of securities under Section
10(b) of the Exchange Act and Exchange Act Rule 10b-5.
[10] Report on the Joint Regulatory
Sales Practice Sweep, prepared by the staff of the NASD, the NYSE, NASAA, and
the Commission’s Office of Compliance Inspections and Examinations (March
1996), at
http://www.sec.gov/news/studies/sweeptoc.htm.