Remarks to the ALI CLE 2013 Conference on Life Insurance Company Products
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Nov. 14, 2013
Good morning. Thank you, Steve, for your kind introduction and for inviting me to speak today. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.
I appreciate the opportunity to be here today, because you are professionals in the dynamic field of investment products issued by insurance companies. I see this field as a vital one, particularly in light of the services and products you offer to the millions of American investors who are gearing up for retirement, and who are shifting their focus from the accumulation of assets to sources of income in retirement that they will not outlive. The work you do – day in and day out – has a profound impact on so many seniors and other investors as they plan for their futures.
This morning I would like to discuss some recent industry developments and related disclosure issues, and some noteworthy developments with regard to mutual fund directors, including both private litigation and Commission enforcement action regarding the important watchdog role of fund boards. I would also like to give you an update on some rulemaking initiatives, and some developments within the Division of Investment Management, including information about our Risk and Examinations Office and our efforts to provide more guidance to our stakeholders. In all of the Division’s initiatives, we work to meet the Division’s mission to protect investors and to promote informed investment decisions on their part. At the same time, we seek to facilitate appropriate innovation in investment products and services, including the important development of retirement income solutions that serve America’s investors.
II. Industry Developments and Related Disclosure Issues
I’d like to begin by discussing some industry developments and related disclosure issues. The Division works actively to monitor emerging industry trends, so that we can promptly address any disclosure and regulatory concerns. One recent trend we’ve noted is the development of deferred annuity riders. These are riders under variable annuity contracts that permit withdrawals from the variable portion of the contract to purchase deferred, fixed income payments under the same contract. They offer investors the ability to build a stream of future annuity payments over time rather than making a single, lump sum purchase payment at the end of the deferral period for annuity payments that begin immediately.
The amounts transferred out of variable subaccounts to purchase these deferred income payments are no longer available to the contract owner, other than through the receipt of the deferred, fixed income payments. This loss of liquidity is an important factor for investors to consider when determining whether to transfer amounts out of the variable portion of the contract. Another important factor for investors to consider is the exposure to the insurer’s credit risk that accompanies a transfer into the general account. Further, an investor who is shopping for a deferred, fixed annuity may have many options available outside the existing variable annuity contract, and there may be better annuity rates available elsewhere, under a separate contract with either the same or another insurer. When the staff reviews variable annuity contracts with this new feature, we are looking for effective disclosure addressing these and any other factors that are material to investors.
I cannot overstate the importance of clear and effective disclosure. When products are being developed, insurers should feel free to reach out to the staff early to discuss any potential issues. Disclosure should not be an afterthought. Insurers should devote resources to careful preparation of information for investors. A prospectus needs to explain how a contract works in an even and balanced way, and the costs and potential pitfalls need to be made clear.
On a related matter, I’d like to discuss the use of names of insurance products and underlying funds that suggest safety or protection from loss. Some of you may have noted that product and fund names including terms like “protected” have come under increased staff scrutiny in recent months. We understand that insurance is often associated with protection against risk or loss. However, when an insurance contract is also an investment product, it is important that the product name not overstate the safety and security provided by insurance aspects of the contract in a way that could be confusing or misleading for investors.
In the Division’s view, when a mutual fund or variable contract uses a name that suggests safety or protection from loss, the name may contribute to investor misunderstanding of the risks associated with the investment and, in some circumstances, could be misleading. I would strongly encourage any sponsor of a fund or contract that exposes investors to market, credit, or other risks, and whose name suggests safety or protection from loss, to reevaluate the name and to consider changing the name, as appropriate, to eliminate the potential for investor misunderstanding.
The staff has recently heightened its scrutiny of fund and contract names suggesting safety or protection from loss. We have concluded that the terms “protected,” “guaranteed,” and similar terms, when used without some additional qualification, may contribute to investor misunderstanding about the potential for loss associated with an investment. This week we published a Guidance Update (2013 – 12) that explains these concerns. As a result, in the disclosure review process, the staff recently requested that some funds and contracts change their names. The staff took this action in response to an increase in the use of the term “protected” in situations where that term was used without a qualification that would adequately describe the nature and limits of any protection offered.
One place where this issue has arisen is with funds that seek to manage volatility, for example, by investing a portion of the fund’s assets in cash, short-term fixed income instruments, short positions on exchange-traded futures, or other investments. This issue also can arise where a fund has entered into a contract with a third party to make up a shortfall in the value of the fund. In those cases, the third party protection may be limited in various ways, for example, by contractual limits on the amount of protection, or by contractual provisions for termination of the third party’s obligation in certain circumstances. In addition, an investor in the fund may be subject to credit risk associated with the third party provider, which could become unable to fulfill its obligation under the contract.
Variable contract names that suggest safety or protection from loss can raise issues that are similar to those raised by funds with third party guarantees. In both cases, an investment is coupled with some protection provided by a third party – in the case of a variable contract, the third party is an insurance company. And in both cases, the third party “protection” typically is limited in significant ways. I urge you to seriously consider the appropriateness of names of your contracts – both those being developed and existing contracts, and consider whether a change would result in a name that is more balanced and representative of the contract’s actual promises.
III Role of Fund Boards
I would now like to discuss the important role that the directors of underlying mutual funds, and particularly the independent directors, play in the compliance programs of those funds. Underlying funds are frequently managed by advisers that are affiliated with the insurance company. In the Division’s view, it is critically important that directors be aware of, and monitor, potential conflicts of interest. For example, a conflict may result from the fact that the amount of an insurance company’s liability under a variable contract may be directly related to the performance of funds that are managed by its affiliate. Prospectuses for underlying funds sometimes acknowledge this type of conflict, in some cases even indicating that the management of a fund could be influenced by the risk exposure faced by the insurance company. Conflicts of interest that may affect the management of a fund are a primary reason behind the important watchdog role given to independent directors under the Investment Company Act. I encourage constant vigilance on the part of boards of directors of any fund that may be subject to conflicting interests.
The Division also has noted recent excessive fee suits brought against investment advisers for their work managing subadvised funds, some of which have involved funds offered under variable insurance contracts. There have been several private actions alleging that a fund’s subadviser does most of the work but the primary adviser retains a large portion of the fee. Fund advisers have a fiduciary duty with regard to the receipt of compensation for services to the funds they manage. Nevertheless, the approval of advisory arrangements for funds is among the most critical functions of a mutual fund board. Thus, I cannot overstate the importance of the watchdog role of the board of directors, and in particular the independent directors, in perfoming this function.
Some recent enforcement actions by the Commission have focused on the process by which boards of registered funds must evaluate and approve their funds’ advisory contracts each year, and related disclosure requirements. For example, one such case involved the trustees of Northern Lights Fund Trust and Northern Lights Variable Trust, which are turnkey mutual fund operations that enable numerous funds to be launched and managed by different advisers and overseen by a single board of trustees. During the time in question, this single board was responsible for overseeing up to 71 series funds, most of which were managed by different, unaffiliated advisers and subadvisers.
In the recently settled Northern Lights case, the Commission found, among other things, that the trustees had approved inaccurate board minutes that served as the basis for disclosure in shareholder reports. The disclosure at issue either misrepresented material information considered by the trustees or omitted material information about how they evaluated certain factors in reaching their decisions to approve certain advisory agreements. For example, one boilerplate disclosure claimed that the trustees had considered peer-group information about the advisory fee when, in fact, no such data had been provided to the trustees.
The Commission also found that certain mutual fund series did not follow their policies and procedures for the trustees' approval of the investment advisers' compliance program. As a result, the Commission found that the trustees and the trusts’ chief compliance officer were responsible for causing violations of the SEC’s fund compliance rule, and the fund administrator caused violations of the Investment Company Act recordkeeping and reporting provisions.
This case highlights the regulatory disclosure requirements for registered funds relating to the process for approving advisory contracts, including the need for accurate, non-boilerplate disclosure of the factors the board considered in approving an advisory contract.
Another case that bears on the role of a fund’s board of directors is the SEC’s action against the former directors of the Regions Morgan Keegan funds and the recent settlement of that case this past summer. In Morgan Keegan, the Commission alleged that the directors of five registered funds failed to fulfill their obligations to fair value certain securities that made up a majority of the funds’ net asset values. This failure may have inadvertently helped the funds’ portfolio manager to fraudulently overvalue the funds’ assets. The directors settled the action by consenting to an order to cease and desist from committing or causing violations of the compliance rule under the Investment Company Act.
This case furthered the important regulatory goal of ensuring that directors of registered funds fulfill their critically important obligations under the Investment Company Act to fair value securities for which market quotations aren’t readily available. I urge you to take a look at the Morgan Keegan order, which reiterates Commission guidance in the area of fair valuation.
It has been suggested that Commission focus on directors and other gatekeepers in our financial system may drive away those who would otherwise serve in these roles, for fear of being second-guessed or blamed for every issue that arises. I acknowledge the concern. However, I would note that being a director where you owe a fiduciary duty to shareholders is aligned with our mission of protecting those investors. And, in addition, the Commission staff does not seek to pursue enforcement action against directors who do their jobs by asking the hard questions, demanding answers, looking for red flags, and addressing any red flags they find.
IV. Rulemaking Initiatives
One area where we have focused significant energy is on rulemaking initiatives. To ensure that we are allocating our resources wisely, we have taken a fresh look at policy initiatives with a view to analyzing those matters based on four factors: first, the risk to be mitigated; second, the urgency associated with a particular initiative; third, the potential impact of an initiative on investors, registrants, capital formation, efficient markets, and the Division’s and the SEC’s operational efficiency; and fourth, the resources associated with a policy initiative. We’re looking at factors that we believe would further the SEC’s mission as well as the impact that various regulatory initiatives would have on investors, capital formation, and efficient markets.
Money Market Fund Proposal
This past June, the Commission issued a new money market fund reform proposal. This proposal is in addition to the reforms adopted in 2010, which were designed to make money market funds more resilient to losses by reducing the interest rate, credit, and liquidity risks of fund portfolios, and by increasing disclosure of fund portfolios. Since 2010, the staff has continued to monitor and study money market mutual funds. In November 2012, the SEC’s Division of Economic and Risk Analysis delivered an extensive economic study to the Commission addressing a series of questions about money market mutual funds. This study considered and conducted analyses of, among other things, investor redemptions from money market mutual funds during the 2008 financial crisis, and the effects of the Commission’s 2010 money market mutual fund reforms.
The money market fund proposal was designed to protect investors and promote market stability, and was designed with four overarching policy goals. These goals were: first, to address money market mutual funds’ vulnerability to heavy redemptions; second, to improve money market mutual funds’ ability to manage and diminish potential contagion resulting from high redemption levels; third, to increase the transparency of money market mutual funds’ risks and risk management practices; and finally, to preserve the current benefits of money market mutual funds for investors to the greatest extent possible.
The proposal includes two principal alternative reforms that could be adopted alone or in combination. One alternative would require a floating net asset value for prime institutional money market funds. The other alternative would allow the use of liquidity fees and redemption gates in times of stress. The proposal includes additional diversification and disclosure measures that would apply under either alternative.
The comment period closed in September, and we received many thoughtful comments, which we appreciate. Some of the letters came from representatives of the variable products industry, and specifically addressed issues related to funds that are offered through variable insurance contracts. All the comment letters received are publicly available on the SEC webpage. The SEC’s rulemaking process is greatly enhanced by the public comments we receive from investors, industry participants, and other parties. The staff will consider carefully the views expressed and the data put forth by all the commenters before formulating a recommendation for final rule amendments.
Variable Annuity Summary Prospectus
Another rulemaking initiative that the Division believes could be very beneficial to investors is variable annuity disclosure reform. The Division continues to believe that the mutual fund summary prospectus, adopted in 2009, and now used successfully by so many funds, may offer a useful model for providing variable annuity disclosure. As you know, variable annuity prospectuses are often long and complex, and we are strongly supportive of more user-friendly disclosure about these products that are sold to seniors and others who are seeking ways to fund their retirement.
We continue to work hard to fashion a framework for disclosure that would help communicate concise, user-friendly information to investors considering these products. The features and pricing of variable annuities can be complex and difficult to understand. We continue to be committed to attacking the problem of long and complex disclosure about variable annuities, while at the same time facilitating disclosure for each variable annuity that will tell the full story – the key facts that investors need to know about the limitations and costs, as well as the benefits, of their investment.
V. Division of Investment Management Developments
As the investment landscape changes, with evolving investor needs and new products designed to meet those needs, we as regulators are challenged every day -- to provide effective oversight and to protect investors. And in the Division, we are working to meet those challenges. We are focusing our energy, trying to become smarter, more strategic, and more targeted.
In our efforts to work smarter, we are focused on the Division as a whole. During the past year, we began a process to better understand our strengths and areas for improvement. Enhanced communication and collaboration are key elements of that initiative. We gathered input from inside the Division as well as from our colleagues throughout the Commission. We identified and prioritized issues confronting the Division and created teams of managers and staff to address these issues. These teams have made recommendations, and I am pleased at the number of creative ideas that were generated. I’d like to highlight a couple of our key changes that are under way.
Risk and Exam Office
One important tool in our efforts to increase communication and collaboration is our newly created Risk and Examinations Office, or “REO.” REO supports the Division’s work primarily through two functions. REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers, and accountants. REO maintains an industry monitoring program that provides ongoing financial analysis of the investment management industry. In particular, REO is charged with monitoring activities of investment companies, investment advisers, and investment products. REO intends to conduct rigorous quantitative and qualitative financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds. The REO monitoring program’s work includes analysis of the information the industry provides through various regulatory reports. REO also draws on industry information from third party providers. In addition, REO conducts an examination program that gathers additional information from the investment management industry to inform the Division’s policy making. Although REO may conduct its own exams, where practical, REO will join examiners from the Commission’s Office of Compliance Inspections and Examinations (OCIE) on their examinations of firms. So far all REO exams have been in association with OCIE.
All of REO’s work will inform the initiatives to which the Division devotes resources and will help inform the rules we recommend.
I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry trends, rather than reacting to past practices. We hope to use the work of REO to make our oversight more efficient and effective. REO represents a new area of focus for the Division of Investment Management, and I expect REO to complement the work of the SEC as a whole.
Another significant development within the Division is the publication of guidance updates. These updates are an important part of our work to enhance our communications with the public. The guidance updates are in addition to our traditional no-action and interpretive letters. One recent example is the guidance on mutual fund names that suggest safety or protection from loss that I mentioned earlier.
Another recent guidance update addressed compliance with the representations and conditions of exemptive orders issued to funds and advisers. The staff noted that funds risk violating the federal securities laws if they fail to comply with the conditions and representations in their orders. The guidance observed one way to address those risks, and offered approaches on how a fund’s compliance program might address conditions relating to board of directors’ review. A final example is a guidance update that summarized the views of the Division staff regarding certain disclosure and compliance matters relevant to funds that invest in commodity interests.
I encourage you to read these and other updates. The staff’s guidance updates are posted on the Division’s recently redesigned website. They are easy to find in the Guidance Updates section, which we are using to get more information out quickly. In addition, the IM website has a section that highlights the Division’s current news, which makes it easy to find the most recent guidance.
I want to thank you for the opportunity to share my thoughts with you. I hope I have been able to convey a sense of the dynamism currently at work in the Division of Investment Management, and the serious commitment the staff of the Division has to the important work we do in the service of the investing public. As always, the staff welcomes your input and your cooperation with us in this important work. Thank you.
 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.
 See, e.g., McClure V. Russell Commodity Strategies Fund, No. 1:13cv12631 (D.Mass. 10/17/2013); Jeremie Cox v. ING Investments LLC, No. 1:2013cv01521 (D.N.J. Aug. 30, 2013); Sivolella v. AXA Equitable Life Ins. Co., No. 11-CV-4194 (D.N.J. Jul. 21, 2011); Southworth v. Hartford Inv. Fin. Servs., LLC, No. 10-CV-878 (D. Del. Oct. 14, 2010); Curran v. Principal Mgmt. Corp., No. 09-CV-433 (S.D. Iowa Oct. 28, 2009).
 In re Northern Lights Compliance Services, LLC, Investment Company Act Release No. 30502 (May 2, 2013), available at http://www.sec.gov/litigation/admin/2013/ic-30502.pdf.
 In the Matter of J. Kenneth Alderman, et al., Investment Company Act Release No. 30300 (Dec. 10, 2012), available at http://www.sec.gov/litigation/admin/2012/ic-30300.pdf.
 In the Matter of J. Kenneth Alderman, CPA, et al. Investment Company Act Release No. 30557 (June 13, 2013), available at http://www.sec.gov/litigation/admin/2013/ic-30557.pdf.
 Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013), 78 FR 36834 (June 19, 2013), available at http://www.sec.gov/rules/proposed/2013/33-9408.pdf.
 U.S. Securities and Exchange Commission Press Release 2013-101, SEC Proposes Money Market Fund Reforms (June 5, 2013), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171575248.
 U.S. Securities and Exchange Commission Press Release 2013-101, SEC Proposes Money Market Fund Reforms (June 5, 2013), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171575248.
 Comment letters from Carl B. Wilkerson, ACLI to Elizabeth M. Murphy, Secretary, SEC dated September 17, 2013, available at http://www.sec.gov/comments/s7-03-13/s70313-212.pdf and from Stephen E. Roth and Frederick R. Bellamy, The Committee of Annuity Insurers to Secretary, SEC dated September 17, 2013, available at http://www.sec.gov/comments/s7-03-13/s70313-183.pdf.
 Fund Names Suggesting Protection from Loss, IM Guidance Update No. 2013-12 (Nov. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-12.pdf.
 Compliance with Exemptive Orders, IM Guidance Update No. 2013-02 (May 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-02.pdf.
 Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests, IM Guidance Update 2013-05 (Aug. 2013) available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf.