It is only through effective training and a comprehensive supervisory system that firms can ensure that customers receive important disclosures concerning these complex products and that they are sold to customers for whom they are suitable. (NASD News Release, Dec. 4, 2004, Mary L. Shapiro, NASD Vice Chairman Regulatory Pricing and Oversight).

Overview

Regulators have for some time been concerned about the suitability of recommendations and adequacy of supervision with respect to the offer and sale of variable annuities. As a result, there have been more targeted examinations, sweeps and investigations, often followed by disciplinary actions and fines levied against firms provoked by what regulators see as abusive sales practices.

In 2005 the NASD instituted 88 cases involving variable annuity sales.¹ These actions involved a range of alleged sales abuses including excessive switching, misleading marketing, failure to disclose material facts, unsuitable sales, inadequate written supervisory procedures, failure to maintain adequate documentation, and failure to supervise variable product transactions. In particular, the regulators emphasized that variable annuities are complex, long-term investments that in some cases are being inappropriately sold to certain classes of investors, such as elderly clients.²

The NASD has indicated that it has been scrutinizing the activities of bank affiliated broker-dealers in this area. We are aware of a number of institutions that are currently responding to an NASD sweep of variable annuity sales practices. Interestingly, this sweep is being conducted by the NASD's Department of Enforcement. Bank affiliated broker-dealers have also been the target of recent NASD enforcement actions. For example, in October 2006, the NASD instituted enforcement proceedings and imposed a significant fine based upon findings that a bank broker-dealer affiliate breached its supervisory obligations related to variable annuity contract sales. Specifically, the NASD found that the firm sometimes failed to provide for reasonable follow-up and review of variable annuity transactions which in some cases impacted retirees.³ A recent Wall Street Journal article entitled, Concern Over Brokers at Banks, discussed the NASD's concern that bank affiliated brokers are not adequately explaining to customers the risks associated with such investments. The article quotes NASD Vice President of Enforcement, Emily Gordy, who suggested that banks may be steering customers in the direction of bank affiliates and questioned the suitability of some of the products these customers were being sold.⁴

The NASD and the Securities and Exchange Commission ("SEC") have issued significant guidance to member firms and associated persons concerning acceptable variable annuity sales practices⁵. In June 2004, the NASD and SEC jointly examined a number of broker-dealers to review sales of variable insurance products and thereafter published a report identifying weaknesses and sound sales practices ("Joint Examination").⁶ The Joint Examination was prompted, according to the regulators, by a large number of customer complaints alleging that customers were sold variable products without fully understanding the products and that the product was not suitable for them. At the same time, the NASD proposed Rule 2821, a new stand alone rule tailored to address deferred variable annuity sales practices which would codify the best practices recommendations discussed in prior industry guidance and in the Joint Examination.⁷ These regulatory and enforcement actions evince a continuing and shared concern over several key areas including training and education, suitability, supervision, and disclosure.

The SEC and NASD have indicated that they will continue to be aggressive in their investigations and enforcement actions with respect to variable annuity sales practices. Accordingly, firms should consider taking a best practices approach to the sale of variable annuities and the development and implementation of an effective supervisory structure.

Sound simple? Not really. The many features of variable annuities, including the new benefits described in the accompanying article by our colleague, Michael Berenson, make establishing best practices particularly challenging. These products require special disclosures, procedures, and controls. In accordance with industry guidance (regulatory and enforcement), a best practices approach must include: adequate employee education and training; well defined suitability and disclosure guidelines; and multi-tiered, fully integrated supervision. A best practices approach must also be fluid, consistently monitored to keep abreast of changing variable products business and adjusted to reflect the latest guidance from regulators, such as proposed NASD Rule 2821, and any applicable state regulations. Of course, firms must always be mindful of and learn from recent enforcement actions.

The purpose of this article is to revisit the historical guidance the regulators have offered firms related to variable annuity sales and further to suggest best practices firms might consider in the critical areas of training and education; suitability; supervision; and customer disclosure.

Best Practices

Effective Education and Training

"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." Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products (June 2004).

Employee education and training are a critical first step to ensuring the suitability of variable annuity sales practices. In their Joint Report, the SEC and NASD found that many firms did not provide adequate education and training to employees. For example, the report found that training of registered representatives did not cover the special features of variable annuities or specific suitability issues. The report also found that supervisors reviewing variable transactions were not sufficiently trained or experienced to identify abusive sales practices. In addition, in its most recent enforcement cases, the NASD censured and imposed significant penalties against two firms because the firms allegedly failed to provide employees with adequate guidance in determining the suitability of exchanges and replacement switches.⁸

Firms must implement an effective education and training program for supervisors and registered representatives addressing their supervisory and suitability obligations. To be effective, this education and training should occur on multiple levels. Firms should have programs to ensure that salesman have a comprehensive understanding of variable annuities in general and the specific products the firm is offering. This understanding should include a thorough knowledge of not only the basic features of a variable annuity but also of the more complex features of the product (e.g., risks associated with sub-accounts, tax consequences, stepped up benefits, riders etc.). Salespersons must fully understand the products, be able to explain them to their customers, compare specific variable annuities to other products and be able to assess the suitability of their recommendations.

Some firms have relied upon wholesalers to supply much of this training. Regulators have raised concerns about this practice. In particular, certain regulators have questioned whether the broker-dealer has reviewed and retained copies of the wholesaler's training materials; whether a supervisor or compliance professional attends some of the presentations and whether the firm is satisfied that it is a comprehensive and objective review of the features, risks, costs and related suitability qualifications. A firm should be familiar with the foregoing and recognize that while wholesaler training can be an important aspect of their program, the primary responsibility for ensuring the adequacy of its education and training is with the firm not with the product supplier.

Because supervisory principals are the first line of defense in detecting and preventing sales practice abuses, it is equally important that firms provide supervisors with appropriate education and training. It is important that supervisors have a sound understanding of both the basic and more intricate features of these products and that the firm has provided them with adequate guidance and tools to assess the suitability of transactions.

NASD NTM 99-35, the Joint Examination, and Rule 2821 each address the importance of employee education and training. Examples of best practices in this area include:

• Conducting training programs and providing written guidance designed to address the sale of variable annuities. Firms should ensure that it clearly explains to salespersons how to make suitability determinations and perform suitability reviews;
• Conducting specialized training for supervisors;
• Educating employees on applicable state rules and regulations.⁹ A firm should ensure that it develops and documents training policies and programs reasonably designed to ensure compliance with industry guidance; and,

As new products and features are introduced, firms must continually update their training and educational programs.

Suitability

"Placing the client's interest first and assessing the suitability of every recommendation are two of the fundamental principles under which every firm must operate in every securities transaction." NASD News Release, 4/29/2005, Mary L. Shapiro, NASD Vice Chairman Regulatory Pricing and Oversight.

Broker-dealers are required to have reasonable grounds for believing that a recommendation for the purchase, sale or exchange of any security is suitable for a customer in light of the customer's financial needs, objectives and circumstances. This suitability requirement means that registered representatives must know their customers fully and evaluate their customers' financial circumstances, objectives, liquidity and other needs and resources before recommending the purchase or exchange of a variable annuity.¹⁰

NASD NTM 99-35, the Joint Examination and Rule 2821 offer useful guidance concerning suitability best practices. At the most basic level, registered representatives should make reasonable efforts to obtain current, comprehensive customer information, including the customer's occupation, marital status, age, number of dependents, risk tolerance, investment experience, liquid net worth, other investments and savings, tax status, and annual income. The registered representative and registered principal must also take time to review with the customer, among other things, the customer's investment objectives, liquidity needs and risk tolerance to determine whether the variable annuity contract as a whole and the underlying sub-accounts recommended to the customer are suitable investments. Special care must be taken when recommending replacements or exchanges between variable products, and special attention paid to confirming the customer's understanding of the risks, their risk tolerance, and investment timelines.

We have also observed that many broker-dealers and bank affiliated broker-dealers implement many of these sound sales practices. Examples include:¹¹

• Establishing and enforcing thresholds. Firms should consider restricting or prohibiting (i) sales of variable annuities to customers over a certain age; (ii) annuity investments that exceed a certain percentage of a customer's net worth; (iii) sales where the source of funds is from a home refinancing or reverse mortgage; or (iv) variable annuity sales into a tax-qualified retirement plan or other tax deferred account.
• Establishing an approved product list.
• Establishing suitability checklists or customer questionnaires for registered representatives regarding the factors to consider in determining the suitability of variable products or underlying funds. Any checklist should include suitability assessments of the products themselves, the underlying sub-accounts, and investment adviser reviews.
• Developing exchange (i.e. 1035 Exchanges) or replacement documents when recommending a replacement explaining both the positive and negative aspects of replacing one variable annuity with another, such as that required by N.Y. State Regulation 60.
• Developing special guidelines and heightened supervisory review of exchange transactions. These might require a comparison of the costs of the two products involved and special explanations if a back-end sales charge will be applied.
• Implementing a quantitative approach to compare recommendations to customer profiles and to ensure the benefits of an annuity outweigh the benefits of alternative investment products.
• Requiring registered representatives to perform a formal suitability analysis supporting a variable annuity recommendation and establishing procedures for supervisors to review this analysis.
• Implementing a methodology for demonstrating that the suitability determination was based on the customer data and customer information collected.

The foregoing determinations at least in some circumstances should be documented and signed by the associated person recommending the transaction. To ensure these requirements are met, firms must also devise an effective system of supervision and controls.

Supervision and Control

"Like any securities firm, bank-affiliated broker-dealers must have adequate supervisory systems and controls for ensuring compliance with regulatory requirements." James S. Shorris, NASD Executive Vice President and Head of Enforcement. NASD News Release, 10/16/2006.

Thorough and well-designed supervisory systems and controls are perhaps the most important aspects of a best practices program for variable annuity sales. SEC, NASD, and SRO rules have long required that firms implement, maintain, and enforce a system of supervision and control governing sales of annuity products.¹² As recent NASD enforcement actions make clear, the NASD believes that some firms have failed to develop adequate systems and controls particularly with respect to the proper follow-up and review of transactions, such as suitability reviews and exception reports.¹³

As with education and training, supervision must occur on multiple levels. First, managers and registered principals must properly supervise salespersons. This necessarily entails reviewing variable annuity recommendations, suitability analyses and transactions. The supervisors should have access to current customer account documentation and the salesperson's written analysis or rationale. Firms also must demonstrate that they supervise managers and registered principals. Similar to the suitability best practices discussed above, this supervisory process should be well documented, so that firms can demonstrate that each level of supervision was properly performed.

NASD NTM 99-35, the Joint Examination and Rule 2821 suggest the following supervisory best practices, many of which are similar to supervisory practices that firms have implemented in the past to address similar concerns involving sales of mutual funds, limited partnerships, and other complex securities. We have observed firms implementing some or all of the following recommendations:¹⁴

• Clearly delineating and designating supervisory responsibility.
• Requiring managers and registered principals to review and approve suitability analyses conducted by registered representatives. It may also be useful for firms to adopt supervisor procedures requiring pre-approval of certain variable annuity sales.
• Requiring managers and registered principals to review and approve sales materials, hypothetical illustrations, and presentations.
• Adopting specific procedures and utilizing compliance systems designed to identify and "red flag" patterns of abusive or suspicious sales practices. Firms should consider implementing automated compliance systems that monitor variable annuity transactions and "red flag" suspicious transactions, and then investigate them.
• Firms should also consider implementing automated systems to produce exception reports which can detect and prevent potential improper sales, such as threshold violations, excessive switching, and improper exchanges.
• To ensure managers and registered principals are enforcing compliance with internal supervisory procedures, firms should have in place a system of follow-up and review to ensure timely responses to exception reports and red flags.
• Pre-approving certain variable annuity sales to ensure compliance with established thresholds, such as restrictions or prohibitions of variable annuity sales to customers above a certain age or sales of variable annuities into tax deferred plans.
• Requiring the salesperson to prepare a written analysis or rationale in certain circumstances.
• Requiring that the customer review and sign the written analysis or recommendation in certain circumstances.
• Requiring supervisors to contact customers in certain circumstances before approving a transaction.
• Establishing a separate, centralized group or designated principal(s) to review and approve variable annuity sales and to review and ensure compliance with established suitability guidelines.
• Implementing an auditable process to ensure supervisory reviews and suitability determinations are taking place and to further ensure that transactions outside of established parameters are detected and prevented.
• Ensuring that accurate and the most up-to-date customer information is on file.

Customer Education and Disclosure to Customers

"You've got to use the tools at your disposal — required disclosures, sales materials, and your sales force — to communicate plainly to your customers what they are buying and how much it costs." Andrew J. Donahue, Director, Division of Investment Management, United States Securities and Exchange Commission, Remarks Before the National Association for Variable Annuities 2006 Compliance and Regulatory Affairs Conference, June 26, 2006.

It is axiomatic that firms and their registered representatives must always deal fairly with their customers. This means that firms and their sales forces fully and accurately disclose to customers all material information in connection with securities transactions. This is particularly critical in the case of variable annuities because of the difficulties in understanding their unique and complex features. Indeed, recent regulatory enforcement actions have been instituted against firms and their salespersons for breaches of this obligation.¹⁵ In those cases, regulators alleged that customers are being sold products they simply don't understand.

Registered principals and representatives should take time to discuss with each customer the salient features of these products such as market risk, liquidity issues (e.g., surrender charges and early withdrawal fees), tax consequences and penalties, and fees associated with these securities (e.g., mortality and expense charges; administrative charges; advisory fees). In addition, to the extent practical, a current prospectus should be discussed with, and provided to, the customer.

Examples of education and disclosure best practices include:

• Member firms and registered representatives should fully and clearly disclose to customers, among other things, the fees, risks, lack of liquidity, and tax implications associated with the variable annuities, and to provide these important disclosures to customers at the point of sale.
• In the case of exchanges or replacements, member firms should provide customers an exchange or replacement analysis document consistent with state requirements for variable product replacement sales.
• Member firms should require, where practical, registered representatives to provide the prospectus for the variable annuity (and if possible, the underlying investment funds) at the point of sale and require clients to sign a prospectus delivery receipt.
• Member firms should use a disclosure and comparison form to disclose to customers, in plain English, among other things, the fees, risks, and surrender periods associated with variable annuities.
• Registered representatives and managers should be available to discuss with customers and explain the information contained in the prospectus.
• Requiring registered representatives fully communicate with customers including preparing documents establishing all proper disclosures have be made to customers, such as having customers fill out questionnaires or other point of sale disclosure documents.
• With regard to the sale of annuities in tax-qualified plans, the registered representative should disclose to the customer that the tax-deferred accrual feature of the variable annuity is unnecessary, and document the reasons the customer believes the annuity meets their financial or investment needs.
• Firms must avoid and/or disclose all potential conflicts such as disparate brokerage commissions for the sale of certain types of products or investment adviser recommendations for asset allocation services within variable annuities in conjunction with wrap accounts or managed account programs based on affiliation or expected payments to the broker-dealer.

Finally, firms must always be mindful of compensation issues related to variable annuity sales practices which can arise within contexts of suitability, supervision, and customer disclosure. Firms should be particularly mindful of special compensation for proprietary products, sales contests, revenue sharing arrangements, or compensation related to variable annuity riders and benefits.¹⁶

Conclusion

There is no "one size fits all" solution to ensuring best supervisory and control practices for variable annuity sales. We can, however, be very certain that regulators will continue to strictly scrutinize these sales particularly through bank channels. As products evolve and become increasingly more complex, firms need to review and revise their education and training programs and supervisory systems and controls. Firms should also continually monitor regulators websites and consider the guidance and warnings given in releases, notices, revised rules, speeches and enforcement actions.

John Hartigan, a partner in the Los Angeles office of Morgan, Lewis & Bockius LLP, is the General Counsel of the BISA. He was formerly the Assistant Director in the SEC's Division of Enforcement. E. Andrew Southerling is a litigation associate in the firm's Washington, DC office. Before joining Morgan Lewis, Andrew was an enforcement attorney in the SEC's Philadelphia office for six years.

Suggested Reading:

Annuity Roundtable Sponsored by NASD and Minnesota Department of Commerce (May 5th, 2006) which can be viewed at www.nasd.com/annuityroundtable;

Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products (June 2004) available at www.sec.gov/news/studies/secnasdvip.pdf

NASD Notices to Members:

SEC Alert, Variable Annuities and Variable Life Products: Questions to Ask (June 9, 2004).

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¹All told, from January 2000 through December 2005 the NASD instituted 286 enforcement actions involving variable annuity sales.

²See e.g., Linsco Private Ledger Corp., (No. EAF0400610003, Dec. 4, 2006) (reminding industry that generally variable annuities are designed to be a long-term investment); Securities America (No. 2005000260, Sept. 14, 2006) (NASD imposed $2.5 million fine and ordered $13.8 million in restitution for failure to review investment recommendations to retirees); John Blount (No. C05030034, Jan. 12, 2004) (NASD found unsuitable variable annuity recommendations to older investors; imposed industry bar and ordered Bount to pay $1.5 million restitution).

³CCO Investment Services Corp., (No. E1120050140, Oct. 16, 2006) (NASD imposed $850,000 fine against firm for failing to establish, maintain and enforce a reasonably designed supervisory system and written procedures related to annuity contract sales, which sometimes impacted elderly customers).

⁴See Concern Over Brokers at Banks, WSJ October 28, 2006.

⁵For example, in 1996, the NASD issued Notice to Members 96-86, which set forth a recommended "best practices" suitability analysis before recommending a variable annuity. In 1999, the NASD issued Notice to Members 99-35, which addressed supervision over sales of variable annuity products. See also, SEC Alert, Variable Annuities and Variable Life Products: Questions to Ask (June 9, 2004).

⁶See Joint SEC/NASD Report on Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products (June 2004) available at www.sec.gov/news/studies/secnasdvip.pdf.

⁷On December 14, 2004 the NASD published for comment proposed Rule 2821. The NASD has since twice amended the proposed rule filing amendment No. 1 on July 8, 2005, and amendment No. 2 on May 4, 2006.

⁸See Securities America, Inc. (No. EAF0400600003, Nov. 27, 2006) (finding inadequate employee knowledge, training, and guidance related to variable annuities including suitability determinations); Linsco Private Ledger Corp., (No. EAF0400610003, Dec. 4, 2006) (finding firm failed to issue sufficient guidance to compliance analysts in assessing suitability of exchanges).

⁹For example, N.Y. State Insurance Regulation 60 requires a two-step customer disclosure process and, with regard to annuity replacements requires firms to provide customers with a document comparing a customer's existing annuity and the proposed replacement. See, e.g., In the Matter of David Lerner Associates (NASD News Release, Mar. 2, 2006) the NASD found that the firm failed to properly educate and train its employees on Regulation 60 compliance.

¹⁰NASD Rule 2310 and the antifraud provisions of the federal securities laws govern suitability. In addition to these securities laws and rules governing suitability, on September 14, 2003 the National Association of Insurance Commissioners ("NAIC") adopted a model regulation entitled Senior Protection in Annuity Transactions. The model regulation requires insurers and producers to use standards to evaluate suitability recommendations similar to those required by the NASD for variable products and has been adopted in one form or another in many states.

¹¹If adopted by the SEC, NASD Rule 2821 will require that before a variable annuity is recommended to a customer, the associate person must have a reasonable basis to believe that:

• The customer has been informed of the material features of the variable annuity, such as the potential surrender period and surrender charges; potential tax penalties mortality and expense fees; investment advisory fees; potential charges and fees of riders; the insurance and investment components of the variable annuity and market risk;
• The customer would benefit from the unique features of a variable annuity (e.g. tax deferred growth, annuitization or a death benefit); and
• The particular variable annuity as a whole and the underlying subaccounts are suitable based on, among other things, the customer's age, annual income, financial situation, investment experience, investment objectives, intended use of the variable annuity, time horizon, existing investment and insurance holdings.

¹²See Securities Exchange Act Section 15(b)(4)(E), NASD Rules 3010 and 3040; and NYSE Rule 342.

¹³See, e.g., CCO Investment Services Corp., (No. E1120050140, Oct. 16, 2006)(finding firm sometimes failed to provide for reasonable follow-up and review to ensure that noted exceptions were adequately addressed).

¹⁴NASD Rule 2821 specifically addresses supervisory reviews of annuity sales, including exchanges. Here, if adopted, the rule would require registered principals to consider the following:

• The extent to which the customer would benefit from a variable annuities unique features;
• The extent to which the customer's age or liquidity needs make the investment appropriate; and
• The extent to which the investment would result in undue concentration of the customer's overall portfolio.

  If the investment involves an exchange, the registered principal shall also consider:

• Surrender charges, extension of surrender period, loss of existing death benefits, and increased fees and charges;
• Whether the customer would benefit from any product enhancements; and
• Whether the customer has exchanged a VA within the past 36 months.

  In addition, Rule 2821 would require that registered principals complete the foregoing review within two business days following the transmission of the customer's application to the insurance company.

¹⁵See, e.g., Nationwide (No. C05040017, May 20, 2004) (NASD found Nationwide failed to disclose to customers charges and fees associated with annuity and further found firm failed to provide a balanced presentation of risks and benefits); see also, In re Raymond Parkins, Jr. (SEC Rel. No. 33-8055, Mar. 18, 2002) (SEC found Parkins made misrepresentations and omissions related to annuity switches).

¹⁶NASD Rule 2820 requires that any sales contests, whether for cash or substantial non-cash prizes, involving variable annuities give equal weight to all products within a given product line. See e.g., David A. Lerner Associates (NASD News Release, 4/13/04) (NASD alleged firm gave greater weight to certain proprietary mutual funds and variable annuities; found firm failed to properly supervise sales contests).