No-Action Letter under:
Investment Company Act -
Section 11

National Association for Variable Annuities;
Insurance Marketplace Standards Assn;
American Council of Life Insurers

June 19, 2001

W. Thomas Conner, Esq.
Vice President and General Counsel
National Association for Variable Annuities
11710 Plaza America Drive
Suite 100
Reston, VA 20190

Paul J. Mason, Esq.
Executive Director
Insurance Marketplace Standards Association
1001 Pennsylvania Ave., N.W.
Suite 500
Washington, DC 20004-2599

Carl B. Wilkerson, Esq.
Chief Counsel, Securities
American Council of Life Insurers
1001 Pennsylvania Ave., N.W.
Suite 500
Washington, DC 20004-2599

Gentlemen:

The Division has recently received a number of inquiries concerning the applicability of the "retail exception" under Section 11 of the Investment Company Act of 1940 when variable annuity contracts issued by an insurer are exchanged for other contracts issued by the same insurer. The purpose of this letter is to explain the Division's view of the "retail exception" and to express our concern that some insurers may be interpreting the "retail exception" too broadly.

Background

In recent years, the variable annuity industry has experienced a substantial increase in tax-free "1035" contract exchanges.¹ Estimates suggest that as much as 40% of new sales of variable annuities are attributable to contract exchanges.² The increase in variable annuity exchanges appears to have been driven to a large degree by the increasing popularity of bonus annuities, where the insurer adds an up-front bonus (typically ranging from 1% to 5%) to contract value.³ Exchanges into bonus annuities often result in the payment of substantial commissions to the brokers who handle these transactions. A contract owner, however, may not benefit from an exchange into a bonus annuity because these annuities often have higher surrender and asset-based charges and longer surrender charge periods, which may more than offset the value of the bonus.⁴

As a result, the Commission is carefully scrutinizing variable annuity exchange activity and bonus annuities through its disclosure review and inspection processes.⁵ Last September, the Commission instituted administrative proceedings against an investment advisory firm for switching involving variable annuities, alleging that the principal in the advisory firm misrepresented and failed to disclose associated sales charges to his clients.⁶ NASD Regulation, Inc., ("NASDR") is also addressing unsuitable exchanges and other problem areas in the sales and marketing of variable annuities.⁷

Recently, the Division has learned that some insurers may be undertaking or contemplating initiatives designed to encourage exchanges from one variable annuity contract to another contract of the same insurer without complying with Section 11 of the Investment Company Act, in reliance on the "retail exception." Congress enacted Section 11 to prevent the sponsors of an investment company from "switching," or inducing shareholders of the investment company to exchange their shares for those of a different investment company, "solely for the purpose of exacting additional selling charges."⁸ We are very concerned with potential insurer violations of Section 11 because of the possibility that contract owners will be induced to make disadvantageous exchanges that result in the payment of additional sales charges and broker compensation.

As you are aware, Section 11 generally prohibits an insurance company and other affiliated insurers from making an offer to its variable annuity contract owners to exchange their existing contracts for other variable annuity contracts issued by the insurer and its affiliates, unless the Commission has issued an order approving the terms of the offer or the offer complies with Commission rules governing exchange offers. ⁹ Rule 11a-2 permits an offer to exchange one variable annuity contract for another variable annuity contract of the same or an affiliated insurer without obtaining Commission approval, subject to requirements designed to address concerns about the imposition of additional sales charges. Specifically, the rule requires that: (i) no surrender charge be deducted at the time of the exchange; and (ii) if both the old and new contracts are subject to surrender charges, then, in computing the surrender charge for the new contract, the insurer must credit the period during which the contract owner held the old contract ("tacking requirement").¹⁰

Last year, the Commission issued an order permitting an insurer to make an exchange offer to certain of its variable annuity contract owners without complying with the tacking requirement of rule 11a-2.¹¹ The new contracts were substantially similar to the existing contracts, except that the insurer would add a two percent bonus to the amounts transferred to the new contracts, and the new contracts would be subject to a new schedule for calculating surrender charges. Because of the two percent bonus and the substantial similarity of the contracts, the exchange offer would be advantageous to a contract owner who held the new contract on a long-term basis and, as a result, did not incur a surrender charge that more than offset the benefit of the bonus credited. The Commission permitted the offer to proceed, subject to conditions designed to address concerns about potential unsuitable exchanges involving contract owners who did not intend to hold the new contracts on a long-term basis and who therefore would be disadvantaged by the new schedule for calculating surrender charges.¹²

The "Retail Exception"

The Division understands that some insurers may be undertaking or contemplating initiatives designed to encourage exchanges from one variable annuity contract to another contract of the same insurer without either complying with rule 11a-2 or seeking a Commission order approving the terms of the exchange offer. These insurers may seek to rely on the "retail exception" under Section 11; and we are concerned that, in some cases, they may be construing the "retail exception" too broadly.

Section 11 applies to an offer by a principal underwriter that is "communicated to holders of securities of a class or series." By contrast, under the "retail exception," Section 11 does not apply to an offer by a principal underwriter "to an individual investor in the course of a retail business conducted by [the] principal underwriter."¹³

We generally interpret the "retail exception" to apply to communications between an individual broker and his or her individual customer, such as when an individual broker recommends an exchange to a particular customer that is not part of an exchange offer to a group or class of contract owners. The Conduct Rules of the National Association of Securities Dealers, Inc. ("NASD"), and federal securities laws other than the Investment Company Act, are designed to protect individual customers from abusive switching in these circumstances.¹⁴ The "retail exception" does not, however, apply to offers by a principal underwriter to a group or class of contract owners, such as an exchange offer to all the holders of a particular contract who meet certain criteria. In addition, the "retail exception" does not apply to any exchange offer by an insurance company separate account. When an exchange offer is made to a group or class of contract owners, or when an insurance company separate account (or an insurance company acting on the separate account's behalf) makes any exchange offer, the protections of Section 11 apply.

A determination of whether an exchange offer falls within the "retail exception" depends on all the facts and circumstances of the offer, and no one factor is determinative. In analyzing whether an exchange offer falls within the "retail exception," the staff considers the following factors, and we believe that an insurer should consider each of these factors in determining whether a particular exchange offer is within the "retail exception:"

• whether an insurer has a plan or intention to promote exchanges from existing contracts into other contracts;

• whether, and how, an insurer dedicates staff and other resources to "asset retention" programs designed to discourage investors from surrendering (e.g., whether the insurer actively promotes exchanges by investors who are at or near the end of the surrender period or simply responds to a particular customer's request to transfer assets to a competitor's annuity);

• whether an insurer has initiated any direct communication with any contract owner regarding a new contract or the availability of an exchange offer from an old contract into a new contract, and the nature of any such communication;

• whether an insurer provides a list of contract owners to a broker-dealer that includes contract owners who have not previously been customers of the broker-dealer receiving the list, the purpose for which the list is provided, and the use that is made of the list;¹⁵

• the nature of any written or oral communications from an insurer to brokers about a new contract or about exchanges from an existing contract into a new contract;¹⁶

• the presence or absence, and the amount and any changes in the amount, of compensation paid to brokers who exchange a contract owner from one contract to a different contract;

• the amount of broker compensation in relation to the services that a broker performs in connection with an exchange;

• whether exchanges are offered on terms designed to encourage exchange activity, such as waiver of the surrender charge on an exchanged contract;

• whether an insurer or principal underwriter has sent any electronic or written communication about a new contract, or the availability of an exchange offer from an existing contract into a new contract, to all existing contract owners or a group of existing contract owners, and the nature of any such communication; and

• the existence and nature of any marketing by an insurer or principal underwriter of a new contract or the availability of an exchange offer from an existing contract into a new contract that is designed, or likely, to reach all existing contract owners or a group of existing contract owners.¹⁷

We believe that the foregoing factors form a useful analytical framework, but we caution that they are not intended to be an exhaustive list of all relevant factors. Other factors may be important in determining whether a particular exchange offer falls within the "retail exception," and an insurer should consider all the facts and circumstances of the offer. Whether or not an exchange offer falls within the "retail exception" cannot be determined by application of a "bright line" mechanical test, and we are not suggesting that any single factor or group of factors dictates whether a particular exchange offer is within the "retail exception."

We would expect any insurer that relies on the "retail exception" to monitor its exchange activity on an ongoing basis to evaluate whether this activity falls within the "retail exception." For example, an insurer should continually assess its communications with existing contract owners to determine whether it is providing information about new contracts or the availability of exchanges that may be inconsistent with reliance on the "retail exception." In addition, an insurer should monitor the overall volume and pattern (e.g., degree of concentration of transactions involving particular broker-dealer firms or registered representatives) of exchange transactions to assess whether they appear to be consistent with the "retail exception."

We wish to emphasize that we view abusive switching of variable annuity contracts very seriously. Section 11 provides important protections against the imposition of additional sales charges to contract owners, and we would be very concerned with any insurer initiative that is designed to encourage exchanges among variable annuity contracts without either complying with rule 11a-2 or seeking a Commission order approving the terms of the exchange offer. We have discussed our concerns with the Commission's Office of Compliance Inspections and Examinations ("OCIE"), and OCIE is scrutinizing variable annuity exchanges for possible violations of Section 11.

We would appreciate it if you would inform your members of the Division's views on the applicability of the "retail exception" to exchanges of variable annuity contracts.

Sincerely,

Susan Nash
Associate Director

Footnotes

1	These exchanges are called "1035" exchanges because Section 1035 of the Internal Revenue Code permits a contract owner to exchange a variable annuity contract without paying tax on the income and investment gains on the original contract.
2	Jeff D. Opdyke, Shifting Annuities May Help Brokers More Than Investors, Wall Street Journal, Feb. 16, 2001, at C1 (citing estimates by Cerulli Associates); Amy S. Friedman, Jackson CEO Takes Variable Annuities to Task, The American Banker, Feb. 8, 2001, at 9 (citing speech by insurance company CEO).
3	Friedman, supra note 2; Matthew Lubanko, Front-End Gain, Long-Term Drain?; A Close Examination of `Bonus' Annuities May Show a Shortfall, The Hartford Courant, Sept. 16, 2000, at E1.
4	See Variable Annuities: What You Should Know, www.sec.gov/investor/pubs/varannty.htm (hard copy available from Commission's Office of Investor Education and Assistance) (explaining costs and benefits of bonus annuities).
5	See Variable Insurance Products: The Challenges of a New Millennium, Keynote Address by Paul Roye, Director, Division of Investment Management, U.S. Securities and Exchange Commission, Before the ALI-ABA Conference on Life Insurance Company Products (Oct. 19, 2000), www.sec.gov/news/speech/spch409.htm.
6	In the Matter of Raymond A. Parkins, Jr., Admin. Proc. File No. 3-10300, Securities Act Rel. No. 7896, Exchange Act Rel. No. 43336, Investment Advisers Act Rel. No. 1898 (Sept. 25, 2000) (Order Instituting Proceedings).
7	NASDR recently issued an investor alert regarding variable annuity exchanges. NASD Regulation Investor Alert: Should You Exchange Your Variable Annuity? (Feb. 15, 2001), www.nasdr.com/alert_02-01.htm. In addition, NASDR filed six separate enforcement actions against firms for the improper marketing and sale of variable annuities. Press Release, NASD Regulation Files Six Enforcement Actions Involving Marketing and Sales of Variable Annuities (Feb. 15, 2001), www.nasdr.com/news/pr2001/ne_section01_022.html.
8	H. Rep. No. 2639, 76th Cong., 3d Sess. 8 (1940).
9	Section 11(a) of the Investment Company Act prohibits a registered open-end investment company or its principal underwriter from making an exchange offer to holders of securities of that company or of any other open-end investment company on any basis other than the relative net asset values of the securities to be exchanged, unless the terms of the offer have been approved by the Commission or are in accordance with Commission rules. Section 11(c) makes the provisions of Section 11(a) applicable, irrespective of the basis of exchange, to any type of offer of exchange of the securities of registered unit investment trusts for the securities of any other investment company. Variable annuities are typically offered by an insurance company through a separate account of the insurance company, which is a registered unit investment trust subject to Section 11(c). The staff has taken the position that Section 11 generally applies to exchange offers involving affiliated investment companies, but does not apply to every exchange offer involving unaffiliated investment companies. Alexander Hamilton Funds (pub. avail. Jul. 20, 1994). By its terms, Section 11 applies only to certain exchange offers involving investment company securities and does not, for example, apply to an exchange offer where either the existing annuity contract or the replacing annuity contract is a fixed annuity with no variable investment options.
10	See rule 11a-2(b)(1)(i) (exchange must be made on the basis of relative net asset values, except for certain deductions that do not include the deduction of a surrender charge on the exchanged security); rule 11a-2(d) ("tacking" requirement).
11	Hartford Life Insurance Company, et al., Investment Company Act Rel. No. 24286 (Feb. 11, 2000) (Notice); Investment Company Act Rel. No. 24334 (Mar. 9, 2000) (Order). See also Northbrook Life Insurance Company, et al., Investment Company Act Rel. No. 24456 (May 16, 2000) (Notice), Investment Company Act Rel. No. 24493 (June 8, 2000) (Order) (permitting offer of variable annuity rider providing reduced charges and other benefits to certain contract owners without complying with tacking requirement of rule 11a-2); Sun Life Assurance Company of Canada (U.S.), et al., Investment Company Act Rel. No. 24995 (May 30, 2001) (Notice) (notice of application for exemptive order permitting exchange offer to certain contract owners of a new contract with a 2% bonus without complying with tacking requirement of rule 11a-2).
12	The insurer agreed to: (i) provide concise, plain English disclosure that the exchange offer was suitable only for contract owners who expect to hold the new contracts as long-term investments and that, in the case of early surrender, the two percent bonus might be more than offset by the surrender charge and the contract owner might be worse off for having accepted the exchange offer; and (ii) maintain records that would permit the Commission to review any exchange activity.
13	Section 11(a)(A) of the Investment Company Act.
14	See, e.g., NASD Conduct Rule 2110 (Standards of Commercial Honor and Principles of Trade) and NASD Conduct Rule 2310 (Recommendations to Customers (Suitability)); Kenneth C. Krull, Admin. Proc. File No. 3-9394, Exchange Act Rel. No. 40768 (Dec. 10, 1998) (sustaining finding by NASD that registered representative violated NASD Conduct Rules by switching of customers' mutual funds), aff'd sub nom. Krull v. SEC, 248 F.3d 907 (9th Cir. 2001); Nesbit v. McNeil, 896 F.2d 380 (9th Cir. 1990) (excessive trading for the purpose of generating commissions found to violate Section 10(b) of the Securities Exchange Act of 1934 and rule 10b-5 thereunder); Laurie Jones Canady, Admin. Proc. File No. 3-8531, Exchange Act Rel. No. 41250 (April 5, 1999) (broker barred from industry based in part on switching among mutual funds and other investments in violation of the antifraud provisions of the Securities Act of 1933 and Securities Exchange Act of 1934), petition for review denied sub nom. Canady v. SEC, 230 F.3d 362 (D.C. Cir. 2000).
15	We recognize that an insurer may routinely provide a broker with lists of, and information about, the broker's own customers, at the broker's request, for reasons unrelated to the promotion of exchanges, such as compliance oversight.
16	We recognize that insurers must communicate with brokers regarding new products. However, those communications should not be designed to encourage exchange activity.
17	Generally, we do not believe that advertising a new variable annuity contract in a publication of general circulation would be indicative that an exchange offer is outside the "retail exception," even when the publication is likely to reach a group of existing contract owners. In limited circumstances, however, such as when an advertisement refers to the availability of exchanges from existing contracts, an advertisement in a publication of general circulation may tend to indicate that an exchange offer is outside the "retail exception."

http://www.sec.gov/divisions/investment/noaction/national061901.htm