Speech by SEC Staff:
|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 Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.|
Thank you and good morning. I am delighted to be here with you today. I have come to regard this conference as an important forum for the exchange of information and ideas affecting the variable insurance products industry. We on the staff of the SEC appreciate the opportunity to participate. This morning, I would like to share some thoughts with you about change in this industry. I am reminded of the famous words of the Greek philosopher Heracleitus who said "all is flux, nothing stays still," and "nothing endures but change," or in the words of that great American philosopher, Bob Dylan, "The times they are a changing." Today change is accelerating at an extraordinary pace as technology is creating a new internet-driven economy. This is having a remarkable impact on the securities markets generally, and on the variable products industry in particular.
Perhaps the most readily apparent change in the industry is in its sheer size and its corresponding impact on the securities markets. Assets dedicated to variable annuities and variable life insurance have experienced tremendous growth in recent years. For example, at the end of 1990, the variable product industry had assets of $34.7 billion. As of July of this year, the industry’s assets totaled $821 billion. That is an increase of well over 2000%.
This growth comes at a time characterized by the rapid introduction of innovative new products, an increasing number of distribution channels, and advances in technology. These changes, of course, bring great challenges for the industry, and also for those of us who are responsible for the legal and regulatory compliance aspects of the business. Our challenge at the Commission as regulators, and yours as industry participants, is to honor the principal of investor protection within this environment of rapid innovation and to ensure that this innovation and change benefits not just the industry, but more importantly, investors.
With this in mind, I want to talk to you about this challenge in terms of some of the specific issues before us at the Commission.
As many of you know, the staff has been taking a hard look at so-called bonus programs, which offer the investor an immediate credit equal to a percentage of purchase payments. From a marketing perspective, these products have substantial appeal. They offer an investor the opportunity to put his or her entire investment – and then some – to work immediately. According to Cerulli Associates, since 1994, assets under management in bonus annuities have grown at more than twice the rate of total variable annuities.
The question was put succinctly in a recent article in the Hartford Courant when the headline asked "Are Bonus Annuities – A Gift Horse? Or a Trojan Horse? We know, that investors generally pay for bonus credits one way or another, such as higher surrender charges, longer surrender charge periods, and higher asset-based charges. We are concerned by the fact that these charges can more than offset the amount of the bonus. We are also concerned with the potential for sales practice abuses because the cost of the bonus may be less visible than the bonus itself. And our concerns are heightened in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in a "1035 exchange," where an investor at or near the end of a surrender charge period takes on a new surrender charge period as a result of the exchange.
We have been paying close attention to disclosure regarding bonus programs. You can expect us to comment on any presentation of a bonus product that does not fully and fairly disclose the downside, as well as the upside, of the product. To that end, we are asking companies to disclose the cost to investors of any bonus – clearly and upfront.
To address our concerns regarding bonus products, we have been focusing on the suitability of bonus transactions through the Commission’s inspections program. We are also working with NASD Regulation to scrutinize sales practices used in marketing variable annuity bonus products.
NASDR, as well as the Insurance Marketplace Standards Association has joined us, in our efforts to heighten attention on bonus products. This past summer NASD Regulation issued a Regulatory & Compliance Alert to assist member firms in ensuring that their bonus product sales material is presented in a fair and balanced manner. The Insurance Marketplace Standards Association has alerted IMSA members and independent assessors to the importance of focusing on sales practices employed in distributing products with bonus features. We applaud the efforts of the NASDR and IMSA in this area.
The responsibilities of compliance and disclosure must be borne by all participants in the industry. We expect that any firm engaged in the distribution of bonus products will pay particularly close attention to sales of these products, ensuring that adequate safeguards exist to prevent unsuitable sales, and flagging for compliance review any individual sales that appear to be unsuitable. Sellers of bonus products should have comprehensive procedures to guard against sales practice abuses. In this regard, the NASD has issued Notice to Members 99-35, which provides a set of guidelines intended to assist broker-dealers in developing appropriate procedures relating to sales of variable annuity contracts. The NASD encourages the use of an exchange or replacement analysis document exploring the basis for replacing one contract with another. The NASD also suggests that members develop "red flag" procedures that can monitor and identify those registered representatives with a higher rate of variable contract replacements and investigate whether these replacements are unsuitable. If you look at trends in recent SEC enforcement actions, you will see that we are not sympathetic in problematic situations when firms either have no compliance procedures or have compliance procedures but do not implement them.
On a related note, it has come to the staff’s attention that some issuers, in an effort to retain assets and stem the tide of outgoing 1035 exchange transactions, may be undertaking initiatives designed to encourage internal exchanges of older products for newer products of the same issuer. The new products may have bonus credits or other new features, but they may also include the additional costs associated with bonuses that I just mentioned.
As you are aware, Section 11 of the 1940 Act prohibits an offer to exchange the securities of a registered unit investment trust for the securities of any other investment company unless the Commission has approved the terms of the offer by exemptive order or an issuer has complied with Rule 11a-2 under the 1940 Act. The so-called "retail exception" to Section 11 excludes from the scope of Section 11 any offers made by a principal underwriter to an individual investor in the course of its retail business. Some issuers apparently are taking an expansive view of the "retail exception," as including issuer programs to encourage internal exchanges. We do not share this expansive view of the "retail exception," which is intended to except individual offers from a broker to an investor. Those who engage in offers prohibited by Section 11 can expect to here from us.
The practice of switching or improper exchanges is one, which we will continue to scrutinize. By "we" I mean not only the Division of Investment Management, but also the Office of Compliance, Inspections and Examinations and the Division of Enforcement. In fact, on September 25, the Commission for the first time instituted proceedings against an investment advisory firm and broker-dealer, for switching involving variable annuities.
Specifically, the principal in the advisory firm is alleged to have induced his investment advisory clients to switch their variable annuity investments by providing them with unfounded, false and misleading justifications for the switches, including false and misleading comparisons of the performance of certain variable annuities and false assurances that the switches would increase the diversification of his clients’ portfolios.
As a result of the alleged fraudulent conduct, the Commission is alleging that the clients in this case incurred unnecessary sales charges of more than $168,000, in some cases lost a portion of their investment principal, and that the broker-dealer received commissions of more than $210,000.
Obviously, this is exactly the type of conduct, which not only we at the Commission, but you in the industry, must guard against and prevent. Let this case be a reminder that we all must be vigilant in policing for this type of practice.
I would now like to turn to the subject of technology and the Internet. Many companies sponsoring variable products are embracing the Internet as a way to educate the public about variable products, sell variable products directly, provide an array of customer services, and support their distribution channels. The Internet has facilitated new opportunities for the direct sale of variable annuities, making it easier for investors to compare and shop for annuities through annuity marketplaces. Through these web sites, investors are offered a number of different companies’ products with lower costs or even no commissions. According to one research organization, there are 15.1 million current annuity owners "on line", defined as annuity owners who regularly use the Internet and e-mail in connection with their annuity investments.
This past summer, President Clinton signed the Electronic Signatures in Global and National Commerce Act into law. The Act is designed to facilitate the use of electronic records and signatures in interstate and foreign commerce. Among other things, the Act provides that, if a statute or regulation requires that information relating to a transaction in interstate commerce be provided to a consumer in writing, the use of an electronic record to provide the information satisfies the "writing" requirement, as long as the consumer consent requirements of the Act are met. Congress directed the Commission to issue, within 30 days after the enactment of the Act, a rule exempting from the consumer consent requirements of the Act, prospectuses of registered investment companies that are provided to permit sales literature to be given to prospective investors.
In July, the Commission adopted Rule 160 to provide this exemption from the consumer consent requirements of the Act. Consistent with Commission interpretations of existing law, the rule permits a registered investment company to provide its prospectus and supplemental sales literature on its web site or by other electronic means without first obtaining an investor’s consent to the electronic format of the prospectus.
This is an area where you can expect further activity from the Commission as technology continues to evolve and as we all work with the new scheme adopted by Congress. Some of the issues we have wrestled with in the past--such as the possibility of all-electronic variable products--remain at the center of our attention. Our goal will be to adapt our regulations to technological advances, provided investor protection can be maintained.
I would like to turn now to the issue of fees and charges. One area where this has been a particular focus is in the increasing number of applications requesting Section 26(b) approval for the substitution of underlying funds. Many of these applications have a common theme. A fund unaffiliated with the insurance company is being replaced with an affiliated fund -- one managed by an affiliate of the insurance company. Often the substituted fund is a newly created series of the insurance company’s proprietary fund group, with investment objectives and policies similar or identical to those of the replaced fund. Even when the substitution is to an unaffiliated fund, often we find substantial revenue sharing arrangements between the insurance company seeking approval of the substitution and management of the proposed new fund.
In reviewing these applications, the staff is concerned when it finds shareholders facing increased advisory fees or 12b-1 fees that, absent a substitution, would be subject to shareholder approval. Under Section 26(b), we can only grant a substitution order if we find it to be consistent with the protection of contract owners. It is difficult, at best, for us to make this finding in the kinds of circumstances I have just outlined.
Before coming to us in these cases, you should consider whether a proposed substitution is designed to benefit contract owners in some tangible way. When a proposed substitution could be accomplished by a fund reorganization with shareholder approval of any fee increases, that alternative should be explored. If you decide to seek a substitution order, you should expect the staff to request, as a condition to granting the order, that you obtain contract owner approval of increases in fees that would normally be subject to a shareholder vote.
At the fund level, the issue of fees has been a focus on Capitol Hill, as well as at the Commission. At the request of Congress, the General Accounting Office completed a study this past summer of mutual fund fees and expenses. The study concluded that additional disclosure could help increase investor awareness and understanding of mutual fund fees and, thereby, promote additional competition by funds on the basis of fees. The report recommends that the Commission require that periodic account statements include additional disclosure about the portion of mutual fund expenses that the investor has borne. The Division is also in the process of completing a review of mutual fund fees and expenses. We will be considering the GAO’s recommendations, as well as alternatives that may provide better information to shareholders at less cost.
The Division has also undertaken a number of recent and ongoing initiatives in this area, including changes to disclosure requirements to make fee disclosure easier to understand; increased focus on investor education about mutual fund fees, including an interactive web-based Mutual Fund Cost Calculator; proposed reporting of investment returns on an after-tax basis in fund prospectuses and shareholder reports; a review of the role of independent directors in setting fund fees, and initiatives intended to help independent directors better fulfill their important role.
Now let me discuss disclosure issues. Both the Commission and the industry have identified a number of areas where disclosure improvements could help investors in variable contracts. We look forward to continued cooperation with you as we all strive to provide investors with the information they need, when they need it, and in a form they can understand.
As you know, the Commission has proposed Form N-6 to improve disclosure to variable life insurance investors by developing, for the first time, a disclosure form specifically tailored for variable life insurance products. We are now in the final stage of refining the form for adoption in light of the many thoughtful comments we received from the industry. Investors will truly be the beneficiaries of better and more understandable disclosure in this area.
A number of variable annuity issuers have expressed concerns to us about the information overload they believe contract owners are faced with when they receive annual reports for all the investment options available under their contract. You have asked us to address this by paring down shareholder report requirements. In looking at this issue, we start from the basic principle that fund shareholders are entitled to receive a shareholder report that tells them what fund management has done for shareholders.
We are currently taking a hard look at disclosure of fund portfolio holdings, with the goal of improving the quality of portfolio schedule information. We are looking at both the format and frequency of portfolio disclosure. Our goal here is to provide information to investors when they need it, while avoiding information overload.
In the area of annual prospectus updates, we are considering an industry proposal that variable annuity issuers not be required to deliver a complete updated contract prospectus to their investors making additional purchase payments. One possibility is that issuers could instead provide a short summary of material changes. Issuers have argued for some time that full annual updates of contract prospectuses are unnecessary and unhelpful because the terms of variable contracts are largely fixed once the contract is issued.
We are also exploring ways to eliminate the need for underlying funds to deliver updated prospectuses to existing shareholders annually. Some of you in the variable insurance industry have suggested to us that we consider allowing underlying funds to provide a short summary of material changes. We explored this idea with the broader fund industry and, frankly, they indicated that they would be unlikely to use such an updating document. We are, however, continuing to explore whether the profile could serve as an annual updating document for funds, which is another idea that some of you in the variable insurance industry have suggested. This could be a more effective way of communicating information to shareholders than delivering an entire new statutory prospectus and could result in significant savings to funds and their shareholders.
I would like to turn now to the issue of advertising. We are very concerned with sponsors of funds and variable contracts engaging in overly aggressive advertising. In January, following an unprecedented year of mutual fund performance, the Commission issued an investor alert reminding mutual fund investors that past performance should never be their only guide when choosing funds. Chairman Levitt also urged those who manage funds not to engage in advertising which would encourage unreasonable expectations and unwise decisions on the part of investors. Given the performance of the securities markets this year, the Chairman’s advice has proved prophetic. Those who have heeded his advice will be in better stead with their shareholders.
Earlier this year, Chairman Levitt also asked the Division of Investment Management and the Office of Compliance Inspections and Examinations to conduct a special review of fund marketing – including web sites, sales literature, and advertisements. The purpose of the review is to determine whether actual portfolio performance and investment strategies are consistent with what funds are saying to the public -- on their web sites, in their advertisements, and in their prospectuses.
At the same time that we are scrutinizing ads for misleading practices, we are proceeding with amendments to Rule 482 in which we will seek to promote balance and responsibility in fund advertising. The Rule 482 revisions will serve as an occasion to remind issuers that technical compliance with the rule may nevertheless run afoul of antifraud prohibitions of the federal securities laws. The proposal also would eliminate the requirement that the substance of the information contained in an advertisement be included in the statutory prospectus. Eliminating this requirement should result in funds and variable contracts being able to provide investors with better and timelier information. We also expect to reexamine the breadth of the provision in rule 482 that permits a variable contract prospectus to be accompanied by a contract application. Specifically, we will take up an issue that has been the subject of inquiries by variable contract issuers, namely, what advertising and other sales materials for underlying funds may accompany a variable contract prospectus and contract application.
I wanted to give you an update on the Commission’s fund governance initiatives. Last year, the Commission issued a rule proposal designed to reaffirm the important role that independent directors play in protecting fund investors, strengthen their hand in dealing with fund management, reinforce their independence, and provide investors with better information to assess the independence of directors.
We have received many thoughtful comments on this initiative that will enable us to improve upon the proposed rules. Many commenters believed that the proposal regarding independent counsel for directors was too paternalistic or that our definition of independent counsel was too rigid. However, we believe that encouraging the use of truly independent counsel by independent directors is one of the strongest pieces of our proposal. A Task Force of the American Bar Association recently issued a report regarding counsel to independent directors of investment companies. The Report is based on the premise that it is essential for independent directors of investment companies to receive legal advice that is unbiased and of high quality. The Report provides guidance to independent directors of funds regarding choosing and retaining legal counsel, as well as guidance regarding counsel's professional responsibilities when representing independent directors. This important effort by the American Bar Association provides guidance in an area where heretofore there had been little guidance for counsel and fund directors. The Report also will inform the SEC staff and the Commission as we advance toward a final rule proposal.
Many commenters also felt that the disclosure requirements, especially as they related to directors' family members, went too far. Our recommendation to the Commission will retain the important disclosures we proposed while scaling back the proposed disclosures where we have been convinced that they would not be useful to investors and would be overly burdensome for directors, such as disclosure with respect to remote family members.
Last fall, I announced that we would take a three-pronged approach to bonus products – coupling our scrutiny in the inspections and disclosure review processes with investor education to heighten awareness of the trade-offs between bonus credits and product fees and charges. I would add that the staff is committed to investor education about variable insurance products generally. In that regard, this past summer we designed an investor brochure that describes variable annuities and how they work, and identifies various annuity features, as well as their fees and charges. The brochure also cautions investors in areas where we believe caution is necessary -- bonus programs, purchases of variable annuities through tax-deferred accounts, careful scrutiny of fees and charges. The brochure is entitled "Variable Annuities: What You Should Know," and it can be found on our web site. A hard copy of the brochure is also available by calling the Commission’s Office of Investor Education & Assistance.
I also want to acknowledge the industry’s recent investor education initiatives. I was very pleased to see the introduction of investor brochures about variable annuities on both the ACLI’s and NAVA’s web sites. We encourage the industry to continue pursuing these kinds of investor education efforts, and would welcome investor education initiatives in the area of variable life products. Having a well-educated investing public will serve the industry well in the long run. Variable insurance products are complicated products; we should do all we can to make them understandable to the average investor.
There are many interesting topics on the agenda for this conference, raising compelling and sometimes unresolved issues facing the variable insurance industry. This is indicative of the dynamism of this industry, and of how the explosive growth you have experienced has resulted in new challenges: business challenges and regulatory challenges. Earlier I referenced the Trojan Horse. In the tale of the Trojan War, the Greeks tried to take over the City of Troy, but its walls were too strong and the army too well-armed. So the Greeks employed an alternate strategy. They built a giant horse, filled it with soldiers and offered it as a symbol of peace. Ignoring the warnings of some against accepting the Greeks strange gift, the people of Troy brought the giant horse inside their walls. The Greek soldiers then emerged and pillaged the city. A brilliant military strategy on the part of the Greeks. In war, there are few rules, and these are often broken. However, in selling securities or variable products, there is no room for the Trojan horse, for misleading or deceiving investors.
In this new millennium, the explosive growth of assets in variable products may make it easy to take investor confidence in these products for granted. In the final analysis, the continued growth and success of the variable products industry will be based on the confidence that the industry’s integrity inspires. Its about maintaining the confidence of the pensioner who reads her monthly statement while walking from the mailbox, the firefighter or teacher whose retirement security is dependent on your products. Maintaining their confidence is our collective challenge.
I know that we can work on this challenge in concert. I, therefore, urge you to work with us in partnership toward a common goal: a healthy industry characterized by full and fair disclosure, the maintenance of high standards and integrity.
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