Speech by SEC Staff:
Remarks Before the 2007 ALI-ABA Life Insurance Company Products Conference
Linda Chatman Thomsen1
Director, Division of Enforcement
U.S. Securities and Exchange Commission
November 8, 2007
There has been much talk these days of the birthday milestones for the baby boomers — a crowd of over 78 million people who are becoming senior citizens in record numbers. For a generation that viewed youth, if not exactly as a virtue, certainly as an attribute to hang on to as long as possible, this transition is a bit of a challenge. And there is nothing any of them can do about it — neither fame nor fortune nor anything else can stop the march of time. Indeed, this past June, a very distinguished Englishman and member of the baby boom generation, was asked about his upcoming 65th birthday. Given all that this particular gentleman has accomplished — he is a cultural icon, massively successful, a Member of the Order of the British Empire, was knighted a decade ago — you might think he would pause to look back and indulge himself in a moment of satisfaction. But no, true to his generation, he said: "[t]he thought is somewhat horrifying … It's like, 'well, no, this can't be me.'"2 Despite his discomfort at that moment, I hope he recognized that the world still loved him, even though he was 64.
Yes, it was Paul McCartney musing about his impending June birthday. If he found the prospect of turning 65 difficult, I wonder what his reaction was when he realized that he wrote the song "When I'm 64" nearly fifty years ago at the ripe old age of 16. Part of the staying power of the Beatles is that they talked to a generation. And, if you look closely, even in their early days they were, consciously or not, talking about issues that confront a maturing generation. "When I'm 64" includes the line "[w]e shall scrimp and save … ,"3 an activity that has moved to the top of the list for many baby boomers, and which presents significant opportunities for the variable insurance industry, as the baby boomers try to figure out how to make their retirement savings last them the rest of a lifetime that is likely to be longer than that of their parents, without much in the way of pension or social security benefits to fall back on.
While the Beatles are remembered for their revolutionary sound and their original lyrics, you may be surprised to hear that they also had some prescient thoughts on the benefits of tax-deferred investing. From the lyrics vault we have: "Now give me money (that's what I want) … Money don't get everything it's true, what it don't get I can't use …"4 — that one I'm sure you know, but the Beatles also realized there was more to financial security than just cash under the mattress, or as they once said: "… baby you're a rich man too, you keep all your money in a big brown bag inside a zoo, what a thing to do …"5 They recognized that a good life insurance policy that might come in handy in times of heartbreak: "Take out some insurance on me baby … if you ever ever say goodbye, I'm gonna go right home and die."6 I don't know if any of your companies have developed riders like that yet. And speaking of death (and taxes) — "Now my advice for those who die, declare the pennies on your eyes, 'cause I'm the taxman … And you're working for no-one but me."7
The business opportunity created by the aging of the baby boomers also brings along with it responsibility — for the variable insurance industry, the responsibility to provide products that meet the needs of investors and are sold in a manner that is forthright and honest. That business opportunity also, unfortunately, brings with it abuses — which is where we come in. I'd like to spend my time with you today talking about our efforts to protect senior citizens (and future senior citizens), as well as some of our other cases that raise issues of importance to the variable insurance industry and its customers. Or, as the Beatles put it, "I've got a word or two to say about the things that you do …"8 but before I do, I must remind you that my views are my own and do not necessarily reflect the views of the Commission or any other member of the staff.
Since joining the Commission, Chairman Cox has made the protection of senior citizens a high priority. The Commission's ongoing initiative to protect senior citizens has several components, including educating older investors about investing wisely and avoiding scams, and using the Commission's examination and enforcement resources to root out problematic practices and prosecute fraudulent conduct that may harm older investors. Just a couple months ago, the Commission held its second Seniors Summit here in Washington, D.C., at which regulators, law enforcement officials, and community groups gathered together to discuss how to best protect older Americans from abusive sales practices and investment fraud. At that summit, securities regulators announced the results of the "free lunch" examination sweep, a successful collaborative effort by the Commission's examination staff, state securities regulators, and FINRA. The "free lunch" sweep examined the sales, disclosure, and supervisory practices of firms that sponsor "free lunch" sales seminars targeting senior citizens. The findings were troubling. The regulators found that, despite how the seminars were often held out, 100% were sales presentations. They also found that 59% of the examinations reflected weak supervisory practices by firms, 50% uncovered exaggerated or misleading advertising claims, 23% found possibly unsuitable recommendations, and 13% uncovered possible fraudulent practices.9 The examiners found that among the most commonly discussed products at these sales seminars were variable annuities, equity-indexed annuities, and mutual funds.
The Division of Enforcement has taken an aggressive stance in combating fraud against elderly investors. Since the end of 2005, the Commission has brought more than 45 enforcement actions involving fraud against seniors. Almost exactly two months ago, we and the Hawaii Securities Commissioner jointly announced the filing of separate fraud actions against a Honolulu-based investment adviser representative who, we alleged, targeted and defrauded members of the senior and retirement communities in Hawaii.10 In our complaint, we alleged that the adviser representative fraudulently induced clients to sign pre-printed, fill-in-the-blank forms, which he proceeded to use to liquidate his elderly clients' securities holdings without their knowledge or consent. We alleged that the representative, who was also a licensed insurance agent, used the proceeds of the unauthorized sales to purchase equity-indexed annuities for which he received substantial, undisclosed commissions totaling about $2 million. About a year prior to that action, we obtained a final judgment by default in a case against a registered representative who recommended to his customers that they sell variable annuity contracts that they already owned so they could purchase new variable annuity contacts with higher principal amounts.11 The representative persuaded his customers to let him temporarily invest the proceeds from the sale of their existing variable annuity contracts but, instead of investing the money as promised, he submitted forged documents to the variable annuity companies to obtain the customers' contract proceeds, and misappropriated the money for his own use. The court enjoined the representative from further violations of the anti-fraud provisions of the federal securities laws, and ordered him to pay disgorgement, prejudgment interest and a civil penalty totaling $5.5 million. In a related criminal action, the representative pleaded guilty to mail fraud charges and was sentenced to more than 11 years in federal prison.
Unfortunately, we have found that schemes to defraud seniors are all too common. In August, we obtained a preliminary injunction against the principal of an advisory firm, the firm itself, and a related company he operated.12 We alleged in our complaint that the principal targeted primarily elderly investors and advised them to surrender existing variable annuity policies, mortgage their residences, and transfer the proceeds to his companies for him to manage.13 According to our complaint, he misrepresented to investors that the investments would pay a 12–15% guaranteed return and that he would pay their mortgages and would accrue in the investor's account any investment returns in excess of the amount necessary to pay the investor's mortgage. We alleged that, rather than using investors' money as promised, the principal failed to make their mortgage payments, and misappropriated their money for his own benefit.
While I know it is tempting to dismiss these sorts of cases as simply involving misconduct by a rogue broker-dealer representative, we often find that the rogue employee was able to carry out his or her fraud in part because of poor oversight, and failures by the employing firm to adequately respond to red flags. This was the case in our 2006 settled administrative action against MetLife for failing to reasonably supervise a registered representative who, we found, defrauded the Fulton County, Georgia, Sheriff's Office by investing $2 million of the Office's money with an entity the representative falsely stated was an affiliate of MetLife, but was actually a company with ties to the representative.14 In connection with this conduct, the representative pleaded guilty to criminal wire fraud charges in federal court and is currently serving a 30-month prison term. We also found that the registered representative induced the Sheriff's Office to purchase a $5.2 million MetLife variable annuity by misrepresenting to the Sheriff's Office that the annuity was a permissible investment for the Office under Georgia state law.15 We found that MetLife failed reasonably to supervise the representative. In particular, we found that MetLife was aware of compliance concerns about the representative from the time he was hired, yet failed to implement heightened supervisory procedures for him and, in fact, allowed him to work from a "detached location" despite continuing compliance concerns and red flags regarding the representative's conduct.
In addition to being concerned about outright fraud relating to the sale of variable insurance products to investors, we are also concerned about sales practice and suitability issues that may arise in the sale and exchange of these products, and will act aggressively when we uncover abuses. The high level of exchange activity involving variable insurance products, combined with the complexity of these products, high commission payouts to representatives, and the heavy marketing of these products to senior investors or investors planning for retirement, makes sales of variable insurance products an area ripe for abuse by the unscrupulous. Another ingredient in this volatile mix is the fact that variable insurance products are sometimes sold by representatives whose primary business is insurance, rather than securities, and who may therefore be less focused on their obligations under the federal securities laws. The "free lunch" sweep I mentioned earlier uncovered numerous instances of possibly unsuitable sales of variable annuities, including one firm at which a review of a sample of customers indicated that 66% had sold a variable annuity in order to purchase a new one.16 The review also revealed that most of those customers had investment time horizons of 3–5 years or less, but were sold annuities that typically were subject to surrender fees for a 7-year period.
The Commission recently approved FINRA's new rule intended to enhance broker-dealer sales practices with respect to purchases and exchanges of variable annuities, on the same day that FINRA issued a regulatory notice to its members reminding them of their obligations relating to senior investors.17 The new FINRA rule has several specific requirements intended to make sure that variable annuities are sold in an appropriate manner. First, the rule imposes a suitability obligation tailored to the specific characteristics of variable annuities. Second, it includes standards and requirements for supervisory review of variable annuity transactions. Third, the rule requires firms to establish and maintain specific written supervisory procedures that are reasonably designed to ensure compliance with the standards set out in the rule. And fourth, the rule contains specific requirements regarding training. We and our colleagues in examinations will be closely watching how firms implement this rule. In this regard, I remind you that unsuitable sales of variable insurance products are likely to also violate the anti-fraud provisions of the federal securities laws.
Let's turn for a moment to market timing and late trading involving variable insurance products. As you know, we have brought quite a few market timing and late trading cases in the last few years – 124 actions since September 2003, to be exact. Variable insurance products, including both variable annuity and variable life insurance products, have proven to be attractive trading vehicles for market timers and late traders. This is because of these products' tax deferral advantages and the potential anonymity provided by the omnibus accounts through which insurance companies submit trades in the underlying mutual funds to those funds. Several of our market timing and late trading cases have been brought against insurance companies, including our cases against CIHC, Conseco, Inviva, and Jefferson National Life Insurance Company18 and, most recently, our case against General American Life Insurance Company and a former senior vice president of the company for their roles in an alleged late trading scheme.19 In the Commission's settled order in the General American case, we found that the executive entered into a written agreement that gave a New York family exclusive late trading privileges in mutual funds underlying private placement life insurance policies the family purchased from General American. The life insurance policies represented about 50% of General American's private placement life insurance business for 2002, and the sales resulted in a significant bonus for the executive. According to the order, various General American personnel became aware of the late trading activity, but failed to take adequate steps to investigate and make sure it was stopped. The Commission fined General American $3.3 million, and imposed disgorgement, interest, and penalties of $163,000 against the executive. In all of these cases, allowing the market timing or late trading activity resulted in financial benefits to the insurance companies involved, at the expense of other shareholders in the mutual funds, who suffered financial harm from the dilution in the value of their investments.
We have also brought numerous cases against traders, such as hedge fund managers, that engaged in fraudulent market timing through variable insurance products.20 Unlike the cases against insurance companies that I just discussed, these are generally cases in which insurance companies actively attempted to prevent market timing through their variable insurance products, but were thwarted in their efforts by traders who employed deceptive tactics to evade the insurance company's detection, or to continue their market timing activities after the insurance company restricted trading in their accounts. We recently obtained a final judgment against one such trader, a hedge fund manager and his firm that carried out a fraudulent scheme to purchase variable annuity contracts in order to engage in market timing for the benefit of the hedge fund.21 The defendants utilized various deceptive tactics to hide their identities from the insurance company, including using trusts and limited liability companies as nominee contract owners and beneficiaries. Through this deception, they made hundreds of thousands of dollars in profits for themselves at the expense of the other shareholders in the underlying mutual funds.
One area in which we have found insurance company affiliates to have sometimes acted in their own best interests, rather than those of fund shareholders, is revenue sharing. In two settled administrative orders, the Commission found that certain insurance company-affiliated mutual fund or variable annuity trust advisers used the funds' or trusts' brokerage commissions to satisfy their own or their affiliated distributors' revenue sharing obligations to broker-dealers for the marketing and distribution of mutual fund and variable annuity products. We found that the advisers failed to disclose to the funds' or trusts' boards this use of fund assets, in violation of their fiduciary duty to disclose material conflicts of interest. We also found that the advisers made misrepresentations or material omissions in fund prospectuses and SAIs regarding the marketing and distribution arrangements. We found that the affiliated distributors, which negotiated and were directly involved in the marketing arrangements, aided and abetted and caused the advisers' violations. In our recent case against several John Hancock and Manulife Financial entities, the Commission ordered respondents to pay a total of $19.2 million in disgorgement and interest, and total penalties of $2 million.22 In our case last year against several Hartford entities, the Commission ordered respondents to pay $40 million in disgorgement and $15 million in penalties.23
This theme of fiduciaries failing to disclose material conflicts of interest to their clients is one we see all too frequently. Our case last year against BISYS Fund Services provides a good example (or sets a bad example, depending how you look at it). We brought a settled administrative action against BISYS, a mutual fund administrator, for aiding and abetting and causing the violations of certain bank advisers to mutual funds and the funds themselves.24 We found that BISYS entered into side agreements with fund advisers in which BISYS agreed to pay a portion of its administration fee to, or for the benefit of, the adviser, often to pay marketing-related expenses, so that the adviser would continue to recommend BISYS to the funds' boards. We found that these side agreements were not disclosed in the funds' prospectuses or SAIs, and that the conflict created by the side agreements was not adequately disclosed to the fund boards. The boards were not given enough information about the side agreements to evaluate whether the terms of the agreements were appropriate, and whether any portion of the payments should have been made under the funds' 12b-1 plans.
Sometimes the theme of conflicts of interest is played out at the personal level, rather than the firm level, as in our cases involving gifts and gratuities, in which financial service firm employees took advantage of their position for personal gain, to the detriment of their duties to the firm and clients. Last year, the Commission brought a settled administrative proceeding against a broker-dealer representative of Jeffries & Co., Inc. in which we found that the representative aided and abetted and caused certain mutual fund traders' violations of one of the Investment Company Act's conflict of interest provisions.25 We found that the broker-dealer representative provided traders from whom he received substantial brokerage business with extensive travel, and lavish entertainment and gifts. The Commission also brought a settled administrative action against his firm and supervisor for failing reasonably to supervise him, including ignoring numerous red flags suggesting he was engaged in misconduct.26 In a case that hits a little closer to home for the insurance industry, last July we obtained a favorable jury verdict in our case against the former principal and compliance officer of a regional broker-dealer based on a kickback scheme in which the broker-dealer provided substantial cash kickbacks and other personal benefits to a trader at New York Life, in exchange for order flow and trades at favorable and excessive prices.27 The jury also found the brokerage firm's former registered representative who executed the trades liable for aiding and abetting the fraudulent price markup scheme. The New York Life trader and the sales representative who provided the kickbacks both pleaded guilty to criminal fraud charges in connection with their roles in the scheme.
I hope that my remarks today have given you a sense of some of the areas in which we are focusing our efforts and where you might want to focus some attention. In this era of the retirement of the baby boomers, business opportunities do abound, but so do opportunities for fraud and overreaching. Being attentive to these risks, and to your obligations to your customers, is not only important to avoid the direct harm that results from being subject to an SEC enforcement action, but also the reputational harm that often results from being associated with a person or entity that has violated the law. That reputational harm may be more difficult to quantify, but clearly can have a significantly adverse impact on your business. Returning to the Beatles for a moment, while you may have been surprised to hear, earlier, that the Beatles had some thoughts on tax-deferred investing, you might be even more surprised to know they appear to have written a song for those of us in Enforcement, as we go about our business of investigating cases and negotiating settlements. It goes like this: "You never give me your money, you only give me your funny paper, and in the middle of negotiations you break down. I never give you my number, I only give my situation, and in the middle of investigation I break down …"28 Of course, we never break down in our investigations or our negotiations – there are too many investors out there we need to protect. As for my number, it is 202-551-4500 – I welcome you to call me anytime if you think of things we should be concerned about.