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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks Before the Financial Services Institute 3rd Annual Public Policy Day


Commissioner Annette L. Nazareth

U.S. Securities and Exchange Commission

Arlington, Virginia
September 13, 2006

I. Introduction

Good morning and thank you for that kind introduction. I appreciate the opportunity to share a regulator's perspective today. I note that from your agenda it appears that you will have many opportunities to be updated today on current issues by several important policymakers.

In preparation for today's conference I took a look at your organization's Web site. In our business we call that "due diligence." I know that many of your members are independent broker-dealers and financial advisers who offer packaged investment products such as mutual funds and variable annuities. I appreciate that many of you have concerns about regulations that you view as burdensome and that may impede your business. And no doubt most of your members are responsible and diligent people who share our concerns that investment professionals act in the best interests of their clients.

I thought I would discuss today why regulators are focusing so much attention on one of the primary products sold by your members — variable annuities. I will also discuss suitability issues concerning another popular product — 529 Plans, as well as supervisory responsibilities of broker-dealers. I hope that I can effectively explain the importance of these issues, while at the same time convey our sensitivity to the unique issues and burdens of small broker-dealers and financial advisors. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1

II. Sales Practice Issues

Variable Annuities. Allow me to be frank — and I speak in "plain English," of course. Variable annuities have been a source of longstanding concern at the Commission, NASD, and other regulators because there are few products that have resulted in more troubling investor complaints. Does this mean that all variable annuity sales are problematic? Absolutely not, but it certainly points to a critical need to focus on a number of issues, including the sales practices applicable to these products. As you undoubtedly know, a variable annuity is a contract between an investor and an insurance company under which the insurer agrees to make periodic payments to the investor, either beginning immediately or at some future date. The value of a variable annuity may vary depending on the performance of the investment options — typically mutual funds — selected by the investor.

The good news about variable annuities is, among other things, that they provide investors with a host of underlying investments and optional features. The bad news, however, is that the myriad of features and fee structures inherent in some annuity products has resulted in confusion for both the representatives who sell them and the investors who purchase them.

Moreover, it is not apparent that optional features are always necessary or useful to the particular investors who purchase them. Even without the additional charges that may accompany these features, the annuity fee structure may be difficult to understand. Variable annuities typically assess surrender charges, mortality and expense risk charges, administrative fees, and the expenses associated with the underlying funds.

The commissions earned by broker dealers from sales of variable annuities have often been higher than commissions earned from other securities typically owned by retail investors. These high commissions create an incentive for registered representatives to recommend these products to investors over products with less lucrative payments. If investors have difficulty understanding the features and costs of what they are purchasing, it may be hard for them to assess which optional features would suit their needs, to compare one variable annuity to another, or to compare a variable annuity to other investment products. Therefore, variable annuity sales raise heightened investor protection concerns. Appropriate suitability determinations and better disclosure would go a long way to allaying these concerns.

As you know, there are suitability requirements in the sales of all products that broker dealers sell to their customers. Suitability gives rise to a "legal obligation" under the federal antifraud provisions as well as an "ethical duty" under SRO rules. But ensuring that a product is suitable also makes good business sense. When investors are treated fairly and honestly by their investment professionals, the industry as a whole benefits. Investor confidence begets more business.

SRO rules regarding suitability are grounded in concepts of professionalism, fair dealing, and just and equitable principles of trade. NASD Rule 2310 squarely addresses suitability determinations and requires broker dealers to make these determinations for each individual customer. According to the rule, the recommendations a broker dealer makes to a customer must have a basis in the customer's particular financial situation and investment objectives. Broker dealers must obtain information about the customer such as their financial and tax status and investment objectives. An even broader requirement, NASD Rule 2110, requires broker dealers to "observe high standards of commercial honor and just and equitable principles of trade." Inherent in the standards and principles mentioned by this rule are appropriate suitability considerations.

As to variable annuities in particular, in 1999, the NASD provided a notice to members with best practices guidelines for variable annuity sales. The notice stated that members and their registered representatives should make reasonable efforts to obtain comprehensive customer information and to discuss relevant facts with each customer. It is reasonable to assume that the NASD desired that its best practices guidelines would be embraced by the industry, inure to the benefit of investors, and mitigate the need for further regulatory action. Unfortunately for all, that was not the case. In the years following the guidelines, the NASD brought literally scores of disciplinary actions in response to troublesome sales practices. I thought that I would highlight some of the suitability issues and sales practices relating to variable annuities that we have found to be particularly troubling. For example, we are concerned about excessive "switching" of variable annuity contracts and about whether the tax implications of variable annuity sales are being carefully considered. One benefit of variable annuities is that taxes are deferred on gains and income until money is withdrawn. Upon withdrawal, however, earnings are taxed as ordinary income.

Also, we have seen variable annuities used to fund retirement accounts that are already tax deferred. Indeed, the tax benefits of variable annuities are largely negated when an annuity is held in a qualified plan because all of the growth within those plans is already tax deferred. In addition, we have broader suitability concerns relating to the sales of variable annuities to seniors. Annuities often have limited liquidity and high surrender charges, and thus may be unsuitable investments for customers who have short term investment objectives or need access to the funds they are seeking to invest.

Regulators have taken action to combat misconduct relating to variable annuities. For example, the Commission and NASD have brought enforcement actions relating to excessive switching and unsuitable sales. In a recent case brought by the NASD for suitability problems, it suspended and fined a broker for selling a variable annuity to an elderly couple, both of whom were 76 years old at the time of the purchase. The broker knew that the customers were about to enter an assisted living facility and had a need for liquidity. He also knew that the customers indicated income as their primary investment objective and wished to preserve the principal of their investment. These factors should have made it clear to the registered representative and the broker-dealer that a variable annuity was an unsuitable investment in this case.

In 2004, in light of the findings from a joint SEC/NASD sweep as well as the numerous disciplinary actions brought against broker-dealers, the NASD determined that it was necessary to codify its best practices guidelines and propose them as rules for comment. Proposed NASD Rule 2821 would establish specific requirements, including a suitability obligation, principal review and approval requirements, and supervisory and training requirements.

The NASD's proposed rule is well known to this group, I am sure. The rule has received extensive public comment and has been amended twice to address the concerns of commentators. Indeed, I note that a number of comments provided by the Financial Services Institute appear to have been reflected in the amendments to the proposal. Obviously, the goal of all of the parties is to provide the necessary protections for investors in the most pragmatic and cost effective manner. I expect that the Commission will consider this rule proposal shortly.

529 Plans. I would next like to discuss 529 plans, which are tax advantaged savings plans that are designed to encourage savings for education costs. Earnings in 529 plans are not subject to federal tax and, in most cases, state tax, so long as a customer uses the withdrawals for eligible expenses. In addition, some states allow their residents to deduct contributions to 529 plans from the state income tax returns for the state that sponsors that plan. This benefit is generally reserved, however, for the 529 plan of the customer's state of residence.

529 plans come in two varieties: a pre paid tuition plan and a college savings plan, the latter of which permits an account holder saving for college to establish an account for a beneficiary for the purpose of paying the beneficiary's eligible college expenses. The account holder typically may choose among several investment options for his or her contributions, which the plan then invests on their behalf.

Generally speaking, I recognize the benefits of vehicles that permit individuals to invest in education, including 529 plans. One certainly cannot overemphasize the value of education to our society. This does not mean, however, that there are no suitability issues presented by the sales of 529 plans. The fact is, with 50 states and the District of Columbia offering at least one type of 529 plan, there are a dizzying number of choices today. The college savings plans can be maddening to compare: many are given different state tax treatment, have different contribution limits, offer multiple investment options and multiple share classes within each investment option, and have different fee structures. As to fees, broker sold college savings plans typically involve loads and annual distribution fees. Other fees for these plans may include enrollment fees, annual maintenance fees, and asset management fees.

In light of the complexity of the college savings plans, it is especially important that brokers make suitable recommendations to their customers. As the shares of 529 plans are municipal securities, their sales are primarily governed by rules of the Municipal Securities Rulemaking Board. The NASD and the Commission, however, are responsible for examining broker dealers and enforcing MSRB rules for securities firms. MSRB Rule G 19 applies to the recommendations and transactions of 529 plans by broker dealers. It requires that broker dealers have reasonable grounds for believing that the recommendation is suitable, based on information available about the investment and information about the customer's financial status, tax status, investment objectives, and other relevant information. Our examiners and NASD staff have been examining broker-dealers with respect to these issues.

The MSRB has stated that broker dealers must recognize that this product is designed to pay for higher education expenses, a purpose that should match the investment objectives of purchasing customers. Therefore, it is reasonable to conclude that a 529 plan would not be a good vehicle for investments that are not earmarked for qualified education expenses. Another concern is that a recommendation would be made to an account holder to invest more funds than he or she might reasonably be expected to use for a single beneficiary.

Other suitability issues arise from recommendations on the underlying investments in the college savings plans. A significant issue in this regard is the age of the beneficiary, because it will generally determine the time in which the account holder will need to draw on the investments for eligible expenses. Broker dealers should consider, for example, whether more conservative investments are appropriate to recommend as beneficiaries near college age. The time that will pass before funds are needed is also important in the determination of which share class is suitable. As share classes have different fee structures, a broker dealer should consider the appropriate class for each particular customer based on their investment objectives.

Also, "rollovers" from one 529 plan to another may be done on a tax free basis. Although changing plans is a significant benefit that permits customers to choose the best option for them, it is not intended to be a tool to permit broker dealers to recommend an excessive number of rollovers. There are also tax implications in the sales of 529 plans. Each state offers a 529 plan. Although customers are not limited to the plan of the state in which they live, many states offer their residents incentives to invest through their plans. As I have indicated, this incentive generally comes in the form of a tax deduction from state income tax. This doesn't necessarily mean that a person's home state will always present the best choice for them, but a broker dealer should consider any foregone tax deductions when making a recommendation.

III. Supervision

SG Cowen and Lehman Brothers Cases. In addition to suitability requirements, another way regulators seek to ensure that sales of complex products are appropriate is by requiring the sales to be properly supervised. This supervision is required by law, as the Exchange Act requires broker-dealers to do this for persons subject to their supervision, with a view towards preventing violations of the federal securities laws. Our policy regarding the failure to supervise is well established. In a recent case, we emphasized that the "responsibility of broker-dealers to supervise their employees by means of effective, established procedures is a critical component in the federal investor protection scheme regulating the securities markets."2

While supervision must be specifically tailored to the broker's business and must address the activities of all of its personnel, firms have significant flexibility in designing that supervisory system. We recognize that supervision cannot be imposed on a "one-size-fits-all" basis. An effective supervisory system is one that takes into account the unique size and structure of the firm. This is clearly an area where more proscriptive rules could be less effective and lead to unnecessary cost. That having been said, a firm cannot design the system and then forget about it. An important component of effective supervision is that it is modified as necessary to reflect changes in the firm's business lines, products, practices, as well as changes in the securities laws. Furthermore, ultimate supervisory responsibility always rests with the member. As the NASD has stated, a member may never contract away its supervisory and compliance activities from its direct control. A member may, however, outsource certain activities that support the performance of its supervisory and compliance responsibilities.

A pair of 2003 joint SEC/NYSE enforcement actions against SG Cowen and Lehman Brothers for failing to supervise producing branch manager Frank Gruttadauria provide particularly compelling examples of instances in which supervision simply broke down.3 Beginning in 1987, while employed at a series of broker-dealers, Mr. Gruttadauria misappropriated over $115 million from his customers and sent them falsified account statements. One of the more remarkable aspects of the cases was that both firms had persons subordinate to Mr. Gruttadauria bear the primary responsibility for overseeing his daily retail-brokerage activity. In addition, the firms did not have adequate systems for applying their procedures for detecting and preventing unauthorized third-party transfers and reviewing incoming and outgoing correspondence.

These enforcement actions in some ways shook the supervisory landscape for broker-dealers. Many firms began to rethink how they had supervised their producing branch managers and how they supervised to prevent misappropriation of client funds. Regulators, including the NASD, also took a fresh look at supervisory requirements in this area.

Broker-dealers that are NASD members must comply with rules that require them to have adequate supervisory systems and written supervisory procedures. NASD Rule 3010, the basic supervisory obligation, provides that member firms must supervise the activities of their registered representatives in a manner "reasonably designed to achieve compliance with applicable securities laws and regulations, and with [NASD rules]." The rule also requires members to establish, maintain, and enforce written procedures for supervising the activities of registered representatives, reviewing customer accounts, and keeping records. Following the Gruttadauria cases, NASD amended the rule to require firms to conduct regular compliance inspections of their office locations and to summarize the inspections in a written report that includes, at a minimum, the testing and verification of the members' policies and procedures in areas such as safeguarding customer funds and securities.

In addition, NASD adopted Rule 3012, which governs supervisory control systems and applies to all firms and business models. The rule requires that firms designate one or more principals who will establish, maintain, and enforce a system of supervisory control policies and procedures that test and verify that a member's supervisory procedures are reasonably designed to comply with applicable securities laws and regulations, and with applicable NASD rules, and to amend those supervisory procedures when testing and verification demonstrate a need to do so. It also requires members to have procedures to review and supervise the customer account activity conducted by branch office managers and others.

IV. Sales to Seniors

I would like to close today by spending a few moments on an area that we expect will get even greater attention in the coming years. This relates to the sale of complex financial products to seniors. A significant portion of the population in the United States is preparing to enter into retirement, with some of its members taking substantial retirement assets with them. The Wall Street Journal recently reported that by 2010, almost half a trillion additional dollars will be rolled into IRAs each year by aging investors looking for more options to fund their retirements.4 In anticipation, the financial services industry has gone to great lengths to anticipate the demands and opportunities created as a result of this retiring generation.

I would urge you to treat sales of complex financial products to seniors with particular care. The Commission has recently announced initiatives that go straight to the heart of investor protection for seniors. In July, the Commission held a Seniors Summit to examine how regulators and others can better coordinate efforts to protect older Americans from investment fraud and abusive sales practices. The Commission also recently announced an initiative with NASAA that would seek to protect seniors from investment fraud and sales of unsuitable products.

With state securities regulators and NASD, our Office of Compliance Inspections and Examinations has initiated a coordinated series of compliance examinations of firms that sponsor so-called "free lunch" sales seminars, often targeted to seniors. We're on the look-out for high pressure sales practices to sell unsuitable financial products to seniors. These exams include firms located in many states, and may be expanded to include other states with a concentration of seniors.

Also, our Enforcement Division has been active in bringing cases aimed specifically at protecting senior investors, and our Office of Investor Education and Assistance has been active in ensuring that seniors are armed with the information they need to assess the various financial products available to them. As more of the baby boomer generation retires, I believe that the Commission's emphasis on protecting senior investors will only increase.

V. Conclusion

I very much appreciate the opportunity to be with you today and to share my thoughts. The success of our markets depends on the integrity and professionalism we all bring to our efforts. I trust you can appreciate that our focus on sales practices, suitability, and supervision are a part of that larger effort. Thank you.



Modified: 09/20/2006