Recent Issues in Variable Annuity and Variable Life Insurance Sales Regulation

Regulators continue to focus a good deal of time and attention on the prevention and detection of inappropriate sales and marketing practices with respect to variable annuities and variable life insurance policies. Of foremost recent concern are the following: (1) unsuitable sales and switching; (2) failure to disclose critical information to customers; (3) market timing and late trading; (4) improper sales contests; and (5) the failure of some broker-dealers to maintain and enforce adequate written supervisory procedures which might prevent or detect abuses in each of the previously mentioned areas.

The numerous recent Notices to Members, speeches, press releases and disciplinary and enforcement actions create a roadmap of regulator concerns in the variable annuity and variable life insurance marketplace. Some of the most significant of these pronouncements and punitive actions are summarized below.

I. SPEECHES, PRESS RELEASES AND NOTICES TO MEMBERS.

• On February 15, 2001, NASD issued an Investor Alert entitled "Should You Exchange Your Variable Annuity," stressing that, although tax law makes 1035 Exchanges free from income tax, investors should be aware of other fees besides income tax which might apply to an annuity exchange. Such fees include surrender charges, mortality and expense risk charges, administrative fees, underlying fund expenses and charges associated with special features, such as guaranteed minimum income benefits. Investors are further warned that brokers are often receiving higher commissions for a variable annuity transaction than for the sale of other securities products.
  
• A January 16, 2002 NASD Investor Alert entitled "Equity-Indexed Annuities – A Complex Choice" explains that Equity-Indexed Annuities ("EIAs") have both fixed and variable annuity characteristics, featuring a minimum guaranteed rate of return combined with an interest rate linked to a market index. The Alert warns that EIAs are typically structured so that they are not registered securities, and therefore not subject to suitability, disclosure and sales practice requirements which would otherwise apply. The wide variety of indexing methods used to calculate the index-linked interest rate makes it hard for investors to predict payouts from their EIA and to compare one EIA to another.
  
• A May 27, 2003 Investor Alert entitled "Variable Annuities: Beyond the Hard Sell" warns investors about fraudulent marketing practices aimed at seniors and sales pitches which attempt "to scare or confuse investors" by claiming that an investment in a variable annuity will protect them in the event of a lawsuit or seizure of assets. The Alert provides simple definitions of common terms and common fees associated with variable products, and explains to investors that variable annuities within IRA's provide no additional tax savings, increase the expense of the IRA, and generate fees and commissions for the salesperson.
  
• On November 3, 2003, NASD Rule IM-2210-2 regarding "Communications with the Public About Variable Life Insurance and Variable Annuities" was amended to state that, although historical performance of a mutual fund may be used to illustrate how a fund would have performed had it been part of a variable annuity or variable life insurance product, such presentations must include all elements of return and deduct applicable charges and expenses. In addition, sales communications may not include the performance of an existing fund if the representative's focus is to sell a similar but new fund (a clone fund or model fund, for example) available in a variable product.
  
• A May 12, 2004 speech by Mary L. Schapiro, Vice Chairman NASD and President of Regulatory Policy and Oversight, focused in part on a perceived increase in abusive variable annuity sales practices, including the targeting of elderly investors who are sometimes encouraged to borrow equity from their homes in order to purchase variable products. Ms. Schapiro stated that NASD had taken more than 80 disciplinary actions in response to troublesome variable annuity sales practices in the previous two year period. Ms. Shapiro also stresses the need to codify the following best practices: (1) heightened disclosure requirements for delivery of not only a prospectus, but "a plain English risk disclosure document" discussing liquidity issues, tax issues, market risk and the availability of a free look; and (2) a registered principal should approve the sale or exchange in writing after considering the investor's age and liquidity.
  
• Notice to Members 04-45, issued in June 2004, requested comment on "Proposed Rule Governing the Purchase, Sale, or Exchange of Deferred Variable Annuities." Previous Notice to Members 99-35 (May 1999) served as the basis for the new rule, which would include suitability, disclosure, principal review, and supervisory and training requirements. NTM 04-45 cites a wide array of misconduct including "excessive switching, misleading marketing, failure to disclose material facts, unsuitable sales, inadequate training and supervision of salespeople and deficient written supervisory procedures."
  
• Notice to Members 04-72, issued in October 2004, is entitled "Transfers of Mutual Funds and Variable Annuities." NTM 04-72 was issued to clarify for members that the previous NTM 02-57 did not allow members to issue negative response letters for the bulk transfer of customer accounts to a different broker-dealer where customers hold mutual funds or variable annuity products directly with the issuer. Rather, a member must obtain the customer's affirmative consent to direct a change in the broker-dealer of record in such a mutual fund or variable annuity account.
  
• Notice to Members 05-27, issued in April 2005, is entitled "Principal Pre-Use Approval of Member Correspondence." NTM 05-27 would amend NASD Rule 2211 to require registered principal pre-use approval of any correspondence sent to 25 or more existing retail customers during a 30-day period. This change was meant to capture, and to subject to SEC and NASD sales and advertising standards, member correspondence to multiple existing customers which encourages existing customers to invest in variable annuities or other securities products.
  
• On June 28, 2005, SEC Commissioner Paul S. Atkins gave a speech before the National Association for Variable Annuities. Atkins calls the then-proposed (now adopted) 75% independent mutual fund board requirement too costly, backed by too little study, and benefiting of too little public input. Atkins also criticizes a recent point-of-sale and confirmation disclosure proposal as bombarding investors with information at a point in the investing process where investors may be confused and overwhelmed. In the case of variable annuities, the complexities and nuances of the product were seen as potentially too extensive to express on the proposed disclosure forms. Atkins suggests internet-based disclosure as a possible alternative, so that investors can have easy access to the desired level of detailed information which they want, when they want it. Atkins also opines that rules relating to market timing risks and fair valuation policy may be quite difficult to implement in the variable product context.
  
• Finally, in a June 29, 2005 article in Ignites, NASD senior vice president and enforcement deputy James Shorris states that the NASD is newly focused on the sale of insurance riders and other add-ons to variable products that are duplicative, conflicting or otherwise unsuitable for customers. There is also concern with representatives changing firms and transferring customer variable accounts with them in order to continue to receive trailing commissions, and with unsuitable sales of illiquid EIAs to elderly customers.

II. EXAMINATIONS AND ENFORCEMENT ACTIONS.

A. Unsuitability of Variable Product For Investor.

As reflected in the discussion in Section I, regulators are quite concerned with recent accounts of large scale misconduct in the form of sales and exchanges of variable annuity products by representatives who execute such transactions either knowing the transaction is unsuitable for the customer, or without investigating whether the transaction is suitable or not. The following disciplinary and enforcement actions reflect a sampling of the regulatory activity in this area:

• Prudential Securities was fined by NASD in January 2005 $2 million and ordered to pay $9.5 million in restitution for alleged annuity sales and switches that violated New York state insurance regulations.
  
• Waddell & Reed and two of its executives were charged by NASD in January 2005 with large scale variable annuity switching. In May 2005, the Firm agreed to pay a $5 million fine and up to $11 million in restitution. The Firm also paid $2 million to state regulators.
  
• Charles Middleton Kelley (NASD Case #C07040053) (representative fined $30,000 and suspended 45 days in July 2004 on charges including claim that he made recommendations to public customers to invest in a variable annuity through the use of margin even though recommendation unsuitable in light of customers' investment objective, income and net worth.)
  
• Dept. of Enforcement v. Gilbert Alan Cardillo, 2004 WL 3202331, *1-2 (NASDR September 22, 2004) (representative fined $6600 and suspended 10 days for making an unsuitable recommendation to a customer; failed to make accurate assessment of client's total assets, income, expenses and plans for the future, recommending variable annuity that did not provide the income or liquidity needed by the client.)
  
• Bernard Edward Nugent, Jr. (NASD Case #C11040031) (fined $5000 and suspended for 2 months for recommending to public customer that he liquidate mutual fund investment and purchase a variable annuity without having made adequate suitability determination.)
  
• Daniel Eric Kelsey (NASD Case #C8A020088)(fined $14,500 and suspended for 60 days for making material misrepresentations or omissions to public customers regarding his personal history and the concept of variable life insurance to induce purchases of these products, including misrepresentations regarding required premium payments and rules for the withdrawal and deposit of funds to policies.)

B. Failure to Disclose Material Facts.

Regulators are focusing on what is seen as widespread misconduct in connection with the sale and exchange of variable annuity products by representatives who facilitate such transactions without disclosing critical information which might affect the customer's decision to purchase or exchange such products. The following reflect regulatory activity in this area:

• Department of Enforcement v. Joseph Rogala, 2004 WL 3202327 (*page ref. not avail.) (NASDR. October 11, 2004) (barring representative from associating with any member firm for, among other infractions, creating misleading illustrations of variable annuity performance that did not describe or identify the variable product or disclose information regarding costs or investment risk.)
  
• Suzanne Baker v. First Montauk Securities Corp., Joseph Jachetti and Louis Inglese, 2005 WL 1529459 (NASD June 13, 2005) (awarding $102,756.33 in damages to Claimant, finding First Montauk Sec. Corp. written supervisory procedures in adequate, and finding that variable products sold to customer were not adequately explained to customer, nor were they suitable for customer.)

C. Market-Timing In Underlying Variable Annuity Sub-Accounts.

SEC and NASD activity in this area is demonstrated by the following:

• Davenport & Co. LLC was fined $450,000 and ordered to pay $288,000+ by NASD in July 2004 in the first case ever brought against a broker-dealer for deceptive market timing in variable annuities. Davenport allegedly helped two hedge funds carry out this practice in sub-accounts of variable annuities without being detected by the affected insurance companies and mutual fund managers who were trying to restrict market timing in order to protect the interests of long term investors.
  
• CIHC, Inc., Conseco Services, LLC and Conseco Equity Sales, Inc., Inviva, Inc., Jefferson National Life Insurance Company, 2004 WL 1771274, *1 (SEC August 9, 2004). Insurance companies agreed to pay $20 million in disgorgement and penalties where SEC alleged the prospectuses through which variable annuities were sold misleadingly represented that the annuities "were not designed for professional market timing organizations." In fact, the companies are alleged to have affirmatively marketed and sold the products to professional market times, and market timing assets were the majority of assets invested in the variable annuity products.
  
• Steven Joseph Iannini (NASD Case #CE4050004) (representative $40,000 fine and suspended or 6 months in June 2005 for facilitating ability of a public customer and his member firm to avoid attempts to limit market-timing trading through variable annuity sub-accounts.)
  
• Alexander Stuart Mundin and Gregory Douglas Siskind (NASD Case #CE4050003) (representatives fined $5000 and suspended for 5 months or 30 days, respectively in June 2005 for facilitating ability of a public customer to avoid attempts to limit market-timing trading through variable annuity sub-accounts.)

D. Inadequate Supervisory Procedures To Monitor Variable Product Sales.

Not surprisingly, variable product sales abuses are often accompanied by situations in which Members have failed to adopt and enforce adequate written supervisory procedures for the marketing and sales of such products. The following is a sampling of disciplinary and enforcement actions in this area:

• SII Investments, Inc. (NASD Case #C05040059) (Firm fined $25,000 in September 2004 for allegedly neglecting to establish, maintain and enforce adequate written supervisory procedures with respect to sale of variable annuities and variable life insurance products.)
  
• Merrill Lynch, Price, Fenner & Smith Inc., 2004 WL 580396, *1,7 (NYSE March 7, 2005) (Firm fined $13,500,000 for alleged failure to make and/or preserve accurate books and records reflecting orders and confirmations for variable annuity product sub-account transactions.)
  
• Greenwich Global LLC (NASD Case #C11050014) (Firm disciplined in June 2005 for alleged failure to establish, maintain and enforce written supervisory procedures for sale of options and variable annuities.)
  
• Fidelity Brokerage Services, LLC, 2004 WL 176095, *3 (NYSE July 8, 2004) (Firm fined $2 million for, inter alia, alleged destruction by branch office employees of variable annuity forms which were incomplete or were completed so as to indicate violation of Firm policies and procedures in order to secure ensure a "no concerns" internal inspection.)

E. Sales Contests Favoring Proprietary Variable Products Over Non-Proprietary Products.

• In July 2005, Hornor, Townsend & Kent, Inc. (NASD Case #02310529) was fined $325,000 and prohibited from variable product sales contests for 3 years. The Firm had been charged with conducting prohibited sales contests awarding exclusive or greater weight to sales of proprietary variable products over non-proprietary products. NASD also found that Firm lacked adequate supervisory procedures with respect to non-cash compensation rules.

Footnotes

¹ Collected July 13, 2005 by Sonya A. Royston.
² A June 2004 29-page Joint SEC/NASD Report On Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products expands on NTM 04-45 and offers a more detailed overview of sound and weak practices in the variable annuity marketplace than it is possible to present here.
³ As with other products, garden-variety forgery of customer signatures on contracts for variable products is a common problem that absorbs a good deal of regulator resources. The forgery issue is not examined here.