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FINRA PROVIDES GUIDANCE ON RULE GOVERNING SALES OF DEFERRED VARIABLE ANNUITIES

On November 6, 2007, the Financial Industry Regulatory Authority ("FINRA") published guidance on new Conduct Rule 2821, which imposes new sales practice and supervisory requirements for FINRA member broker-dealers selling deferred variable annuities. A copy of FINRA’s Notice to Members on Rule 2821 may be obtained at www.finra.org/RulesRegulation/NoticestoMembers/2007NoticestoMembers/P037403.

The new rule has four primary components: (1) a new suitability requirement tailored for the product; (2) principal review standards; (3) written supervisory procedures requirement; and (4) member training programs designed to ensure compliance with the requirements of the rule.
The rule becomes effective on May 5, 2008.

Suitability Requirements

Under the new suitability requirement (which is in addition to, not in place of existing requirements under FINRA Conduct Rule 2310), before selling a deferred variable annuity, the member must have a reasonable basis to believe that:

• The customer has been informed, in general terms, of various features of deferred variable annuities;
• The customer would benefit from certain features of the product, such as tax deferred growth, annuitization, or a death or living benefit;
• The particular deferred variable annuity that the member is recommending, the underlying subaccounts to which funds are allocated at the time of the transaction, and the riders and similar product enhancements are suitable (and in the case of an exchange that the transaction as a whole is suitable) for the customer based on the information the registered representative selling the product is required to make a reasonable effort to obtain.

Prior to recommending that a customer exchange a deferred variable annuity, the FINRA member firm’s registered representative must also consider whether:

• The customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits, or be subject to increased fees or charges;
• The customer would benefit from product enhancements and improvements; and
• The customer’s account has had another deferred variable annuity exchange within the preceding 36 months.

The registered representative must also consider various customer-specific information when recommending a deferred variable annuity, including the customer’s "age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred variable annuity, investment time horizon, existing assets (including investment and life insurance holdings), liquidity needs, liquid net worth, risk tolerance, tax status, and such other information used or considered to be reasonable by the member or person associated with the member in making recommendations to customers." The registered representative must document these considerations and sign the documentation.

Principal Review

A registered principal must review the transaction and determine whether he or she approves of it prior to transmitting the customer’s application to the issuing insurance company for processing, but no later than seven business days after the customer signs the application. The principal may approve the transaction only if he or she has determined that there is a reasonable basis to believe that the transaction may be suitable, in light of the factors mentioned above as well as the personal information ordinarily taken into account in a suitability determination (i.e., customer age, financial situation and needs, investment experience, investment objectives, etc.), each of which is enumerated in the new rule. The principal must document, date and sign each of the determinations that the new rule requires him or her to make, regardless of whether he or she approves the transaction.

Exemptions from SEC Rules 15c3-1, 15c3-3

Under new rule 2821, broker-dealers are permitted to wait up to seven days before completing their review of applications to purchase deferred variable annuities and forwarding them to the issuing insurance company. The SEC therefore also granted exemptions from Rules 15c3-1 (net capital) and 15c3-3 (holding customer funds and securities), to permit firms selling deferred variable annuities to hold customer funds received in order to purchase the instruments for up to seven days without raising the firm’s net capital requirements or requiring the firm to become fully computing. To comply with the exemptive order, checks must be made out to the issuing insurance company, and the broker-dealer must: (1) promptly transmit the check, no later than noon of the business day following the date a registered principal reviews and determines whether to approve the purchase or exchange of the deferred variable annuity; and (2) maintain a copy of each check, as well as a record of the date the check was received from the customer and the date it was transmitted to the insurance company or returned to the customer (if the transaction or exchange was not approved).

Written Supervisory Procedures

FINRA member firms are also required to develop and maintain written supervisory procedures that are reasonably designed to achieve compliance with the new rule. The procedures must include surveillance procedures to determine if registered representatives have rates of deferred variable annuity exchanges transactions that raise concerns over their compliance with the new rule. FINRA member firms are also required to have policies and procedures reasonably designed to implement corrective to address inappropriate exchanges and such conduct.

Training Programs

FINRA member firms are also required to develop and implement training programs that are tailored to educate registered representatives and registered principal on the material features of deferred variable annuities and the requirements of new Conduct Rule 2821.

Use of Automated Supervisory Systems

FINRA Conduct Rule 2821 does not preclude member firms from using automated supervisory systems (or a mix of automated and manual supervisory systems) to facilitate compliance with the rule. Firms that rely on automated supervisory systems for compliance with Rule 2821 must, at a minimum, require one or more principals to (1) approve the criteria that the automated supervisory system uses; (2) audit and update the automated supervisory system as necessary to ensure compliance; and (3) review exception reports the automated supervisory system creates.

As stated above, the rule becomes effective on May 5, 2008.

For more information on the application of GLBA to banks and broker-dealers, please contact, in Los Angeles, John F. Hartigan, 213.612.2630, jhartigan@morganlewis.com; and in Washington, D.C., Kathleen W. Collins, 202.739.5642, kcollins@morganlewis.com; or Jack P. Drogin, 202.739.5380, jdrogin@morganlewis.com.