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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Understanding Securities Products of Insurance Companies
Practicing Law Institute 2003 Conference


Paul F. Roye

Director, Division of Investment Management
U.S. Securities & Exchange Commission

New York, New York
January 10, 2003

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

I. Introduction

Thank you and good afternoon. It is a pleasure to be here with you again at this conference focused on understanding the securities products of insurance companies. However, before I begin, I must, as always, indicate that my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

As you are all aware, the variable insurance product industry has faced new challenges over the last year as a result of a slumping stock market. According to the National Association for Variable Annuities, combined net assets of variable annuities declined approximately 15% during the first three quarters of 2002, which follows a fall in net assets of more than 7% in 2001. Declining asset values have forced some variable annuity providers to increase reserves in order to cover obligations associated with guaranteed death benefits. As the markets have dropped, the value of variable annuity death benefits has in some cases exceeded the value of their corresponding variable annuity contracts. Providers, as a result, are on the hook to cover these death benefits upon an insured's death, which could expose companies to losses. Similarly, shrinking assets have negatively affected the ability of variable annuity and variable life providers to recoup past marketing and distribution costs, which depends upon generating sufficient asset-based fee revenue. Some companies have already been forced to take write-offs against current operating income due to the inability to recoup these costs.

Not surprisingly, variable annuity sales have declined during the last year. VARDS Info-One reported that third-quarter 2002 sales were down 3% from second-quarter sales, which in turn were down from first-quarter sales. While this is not an encouraging trend, one bright spot in the industry is the steady increase in sales of variable annuities sold by banks. One recent report indicates that banks sold $3.5 billion worth of new variable annuities in September 2002, a 29% gain over August sales of $2.7 billion and a 55% gain over the monthly average of $96 million.

In the meantime, the Commission has acted on a number of new regulatory initiatives over the last year, driven primarily by the broad mandates of the Sarbanes-Oxley Act of 2002 and the USA Patriot Act of 2001. As a result, variable product issuers face the additional challenge of compliance with new regulatory requirements stemming from these statutes.

Overall, this is a very challenging time for the variable products industry. But I believe that this industry is vibrant and strong, and will weather the current storms. As I'm sure you have recognized in the course of this conference, the study of variable insurance products and the variable products industry are very interesting, and the regulation of these products is a complicated but a fascinating aspect of securities law. While I am sure that this conference has provided you with a nuts and bolts review of the regulation of variable insurance products, I thought it would be useful for you if I reviewed several of the Commission's recent regulatory initiatives and highlight how these initiatives relate to the variable products industry.

II. Recent Developments

It may not be readily apparent from the recent headlines in the newspapers, but the Commission has been extremely productive this past year under Chairman Pitt's leadership. We have been working on what may be the most aggressive reform agenda in the history of the Commission. The Commission has undertaken numerous initiatives in the areas of enforcement, corporate governance and disclosure, regulation of market participants and accounting reform. In fiscal year 2002, the Commission brought a record number of enforcements cases, 24% more than in 2001, including a record number of actions for financial reporting and other disclosure violations. The Commission has called for accelerated filings of periodic reports of operating companies, more timely disclosure of insider transactions, and CEO/CFO certifications of companies' quarterly and annual reports. The Commission has also launched investigations into the performance of rating agencies and the implications of hedge fund growth.

To stem the erosion of investor confidence in our markets that resulted from the spate of recent corporate scandals and failures, the Commission has made timely and effective disclosures a priority, and has undertaken a number of initiatives to further this goal in the investment management area. These include proposed rules regarding mutual fund and investment adviser proxy voting disclosure, proposed amendments to the mutual fund advertising rules, and the adoption of a new registration form for variable life insurance policies. They also include the launch of the Investment Adviser Public Disclosure Website, whereby disciplinary and other information regarding advisers is readily accessible over the Internet.

Chairman Pitt has also stressed the need to update and modernize our rules. In this regard, the Commission has proposed amendments to the custody rules for investment companies and investment advisers, and expanded the scope of the fund merger rule. The Commission also issued a concept release on actively-managed exchange traded funds, and approved the first exchange-traded funds based on fixed-income indices. This past November, the Commission issued a proposed rule to exempt research and development companies from the provisions of the Investment Company Act, a move that represents a rethinking in the Commission's traditional approach to investment company status issues. Just last month, the Commission proposed rule and form amendments designed to improve the periodic disclosure provided by mutual funds about their portfolio investments, costs, and past performance. Additionally, the Commission adopted a rule permitting Internet investment advisers to register with the Commission, and earlier this week the Commission expanded the scope of exemptive rules that permit certain affiliated transactions consistent with investor protection. Clearly, the Commission has been busy under Chairman Pitt's stewardship.

III. Statutory Mandates

As I mentioned, driving many of the Commission's recent reforms are two pieces of sweeping legislation enacted in response to the events of September 11, and the rash of corporate scandals and failures occurring in early 2002. These statutes, the USA PATRIOT Act of 2001 and the Sarbanes-Oxley Act of 2002, each mandate far-reaching reforms in the regulation of our financial markets. The Commission and the staff have been devoting substantial time and attention to fulfilling these mandates under tight implementing deadlines imposed by each Act.


The Patriot Act is aimed at preventing, detecting and prosecuting international money laundering and terrorist financing activity. The Act's requirements generally apply to all financial institutions, including investment companies and insurance companies. The Treasury Department, with the assistance of the Commission and other federal financial regulators, has adopted, and proposed for adoption, rules under the PATRIOT Act designed to adapt the anti-money laundering program requirements of the Bank Secrecy Act to particular financial institutions. Mutual funds have been one major focus of these rules, in part, because mutual fund assets represent such a large percentage of assets held by all financial institutions. One of our principal roles has been to assist Treasury Department staff in understanding the fund industry and fashioning an anti-money laundering framework consistent with the requirements of Congress' mandate, while recognizing the unique characteristics of the fund industry.

In April of last year, Treasury, through its Financial Crimes Enforcement Network or FinCEN, issued an interim final rule requiring mutual funds to develop and implement anti-money laundering programs reasonably designed to prevent funds from being used to launder money or finance terrorist activities.

The Commission also proposed, in a joint rule-making with the Treasury Department, to require mutual funds to adopt procedures to verify the identities of their customers and to keep records related to their customer verification programs. Last week a joint report to Congress was released by the Commission, the Treasury and the Federal Reserve Board recommending effective regulations to apply the anti-money laundering requirements of the Bank Secrecy Act to various types of investment companies. The report provides a comprehensive discussion of the many types of investment companies, including their characteristics and functions. The report then identifies existing and recommended regulations for the various categories of investment companies, considering their potential vulnerability to money laundering.

Up until this past September, FinCEN had deferred the anti-money laundering program requirements that would have applied to the insurance industry in order to provide Treasury with time to study the industry and to consider how anti-money laundering controls could best be applied to the industry. On September 26 of last year, Treasury, through FinCEN, issued a proposed rule to prescribe minimum standards for anti-money laundering programs for insurance companies. In its notice, FinCEN states that, in its view, the most significant money laundering risks in the insurance industry are found in life insurance and annuity products, because such products allow a customer to place large amounts of funds into the financial system and seamlessly transfer such funds to disguise their true origin. Therefore, FinCEN has focused the proposed rule on insurance products with investment features as possessing the ability to store value and transfer that value to another person. If you question the need for regulation in this area, the preamble to the proposed rule describes in some detail ways in which narcotics money launderers have used life insurance products to launder funds effectively.

The proposed rule requires that each insurance company develop and implement an anti-money laundering program reasonably designed to prevent the insurance company from being used to facilitate money laundering or the financing of terrorist activities. The program must include minimum requirements similar to those for mutual fund anti-money laundering programs.

The FinCEN proposal does recognize that insurance companies frequently conduct their operations through agents and third party service providers. The proposal thus provides that an insurance company may delegate some elements of the compliance program to an agent or third party. However, the insurance company remains fully responsible for the effectiveness of the program and for the availability of information and records.

In a separate proposal, FinCEN issued notice of a proposed rulemaking that would require insurance companies to report suspicious transactions to the Treasury Department.

We expect that more rulemaking implementing the Patriot Act will be forthcoming in the weeks ahead.

B. Sarbanes-Oxley

With the enactment of Sarbanes-Oxley, President Bush and the Congress set the tone for broad, swift reform designed to restore investor confidence in our markets through sweeping corporate disclosure and financial reporting initiatives. Among other things, the Act creates a new oversight board for the accounting profession, mandates new measures intended to promote auditor independence, adds new disclosure requirements for public companies, and strengthens the criminal penalties for securities fraud.

Earlier this week, the Commission proposed a new rule to direct the national securities exchanges and associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements of Sarbanes-Oxley. These requirements relate to the independence of audit committee members, the responsibility of the audit committee to select and oversee the issuer's independent auditors, procedures for handling complaints regarding accounting practices, the authority of the audit committee to engage advisers and funding for the independent auditors and any outside advisers engaged by the audit committee.

Section 302 of the Sarbanes-Oxley Act also imposes certain certification requirements to enhance the direct responsibility of senior corporate management for financial reporting and for the quality of financial disclosures made by public companies, including investment companies. This past August, the Commission adopted rules under Section 302 to implement the certification requirement for registered investment companies. Rule 30a-2 requires the principal executive and financial officers of a registered investment company that files periodic reports under the Securities Exchange Act to certify the company's semi-annual reports on Form N-SAR, as well as the financial statements on which the financial information in Form N-SAR is based. The rule requires that each N-SAR include a certification stating that the certifying officer has reviewed the report; that based on his or her knowledge, the report does not contain any untrue statement of a material fact or any material omissions; and that he or she and any other certifying officers are responsible for establishing and maintaining disclosure controls and procedures that ensure that material information is made known to them and that they have evaluated those controls and procedures and reported on their conclusions within 90 days prior to the report filing date. The rule also requires that the certifying officer has disclosed to the auditors all significant deficiencies in the internal controls that could adversely affect reporting, as well as any fraud involving employees who have a role in internal controls. There is also a requirement to report whether or not there were significant changes in internal controls or significant factors affecting those controls, including corrective actions.

As you know, separate accounts organized as unit investment trusts, or UITs, are unmanaged and are not themselves corporate entities and hence do not themselves have a principal executive officer or principal financial officer to certify a report. Rule 30a-2 states that the certification must be signed by principal executive officers and principal financial officers of the investment company or persons performing similar functions at the time of filing the report. Our release accompanying the final rule states that, in the case of a UIT, the required certification should be signed by personnel of the sponsor, trustee, depositor or custodian who perform functions similar to those of a principal executive officer and principal financial officer on behalf of the trust. In the variable products context, this typically would mean officers of the insurance company.

The Commission also has pending a proposed rule designed to better implement the intent of Section 302 of Sarbanes-Oxley by requiring registered funds to certify the shareholder reports that they file with the Commission. This certification would be made on proposed new Form N-CSR. UITs generally are not required to transmit reports to shareholders containing financial statements, so they are not covered by this proposal. The Commission also proposed a rule that would require every registered investment company to maintain disclosure controls and procedures designed to ensure that the information required in its disclosure documents is recorded, processed, summarized, and reported on a timely basis. We are currently reviewing the comments on these proposals, including the issue of whether certification should be required for both forms N-SAR and N-CSR.

There are a number of other issues under Sarbanes-Oxley that will have an impact on investment companies and insurance products. On October 16 of last year, the Commission proposed new rules that would require registered funds to disclose whether they, and their investment advisers and principal underwriters, have adopted a code of ethics for their senior executive and financial officers. The rules would not require companies to adopt codes of ethics, but only to disclose whether they have such codes. Now, as some of you know, Rule 17j-1 of the Investment Company Act already requires funds to have codes of ethics designed to deter conflicts of interest by advisory personnel when they buy or sell securities for their own accounts. However, the proposed new disclosure requirements are designed to address a broader range of ethical conduct issues, including: the handling of conflicts of interest between personal and professional relationships; full, fair, and accurate filings with the Commission; and compliance with applicable laws and regulations.

As the Commission noted in the proposal, a unit investment trust does not have a corporate-type management structure, and therefore would not be required to disclose whether it has a code of ethics because it has no officers. For UITs, the rule proposes to require disclosure with respect to codes of ethics of the trust's sponsor, depositor, trustee, or in some cases its principal underwriter.

The Commission also proposed rules that would require a registered fund to disclose whether its audit committee includes at least one member who is a "financial expert." Specifically, proposed Form N-CSR would require a fund to disclose annually: (i) the number of financial experts serving on the audit committee; (ii) the names of the financial experts; (iii) whether the financial expert or experts are independent; and (iv) if the audit committee does not include a financial expert, disclosure of that fact and an explanation of why it has no financial expert.

The proposal defines "financial expert" to include individuals with certain attributes specified in the statute, and includes a number of factors that a board of directors must consider when determining whether an individual has these attributes. We have specifically asked for comment on whether this definition should be modified in any way in the case of investment companies.

The Commission also has proposed rules under Sarbanes-Oxley that would prohibit officers and directors of an issuer, and anyone acting under their direction, from taking action to influence the auditor of the issuer's financial statements fraudulently. The proposed rules would cover officers and directors of investment companies, as well as those of investment advisers and other entities, who may be in a position to influence a fund's auditor.

This past November, the Commission proposed a rule that would require auditors of funds to maintain work papers and certain other documents relevant to their audits and review of financial statements. It would also require disclosure to investors of fees and other information related to audit and non-audit services performed by auditors, and require the reporting of certain matters to a fund's audit committee. In addition, this proposed rule would require partner rotation at the accounting firm that performs the audit, and would establish conditions under which accounting firms would not be considered independent for purposes of performing audits of public company financial statements.

C. The Attorney Conduct Rule

Of particular interest to this group should be the recent rule proposals under Sarbanes-Oxley that set forth minimum standards of conduct for attorneys appearing and practicing before the Commission in their representation of issuers. In the proposing release, the Commission noted that attorneys play a varied and crucial role in the Commission's processes. Investors rely on Commission filings prepared by attorneys on behalf of issuers, in making their investment decisions. In this regard, the proposing release noted, "the Commission and the investing public must be able to rely on the integrity of in-house and retained lawyers who represent issuers."

As I am sure you are aware, the actions of some attorneys in certain recent corporate scandals have brought increased scrutiny on the legal profession. Indeed, the preliminary report of the ABA's Task Force on Corporate Accountability this past July concluded that "the system of corporate governance at many public companies has failed dramatically." It went on to acknowledge that attorneys representing and advising corporate clients "bear some share of the blame for this failure." In this regard, Section 307 of the Sarbanes-Oxley Act called on the Commission to adopt a rule requiring an attorney to report evidence of a material violation of securities laws or breach of fiduciary duty to the chief legal counsel or the chief executive officer of the company; and, if they do not deal with the problem, then the attorney must report the evidence to the audit committee, another committee of independent directors, or the full board of directors.

We are analyzing the comments on this proposal, and in particular, comments on how the rule could apply to lawyers representing clients in the investment management area.

In each of the Sarbanes-Oxley rule proposals, the Commission has endeavored to apply the statutory requirements in a manner that is true to Congress' intent in enacting these provisions. Thus, in some cases the requirements go beyond application to funds as "issuers" and extend the requirements to a fund's investment adviser, underwriter or their officers and directors. Given the external nature of typical fund management, the Commission determined that extending the reach of certain of the provisions in this manner was necessary to implement Congressional intent. Again, we are carefully analyzing the comments on these pending rule proposals.

IV. Other Division Initiatives

Although our statutory mandates have kept us busy of late, we have also been engaged in other initiatives. Chairman Pitt has made more useful, understandable and accessible disclosures to investors a priority within the Commission, and we have recently taken several steps to further this objective.

A. Variable Products Registration Statements

Of particular interest to the variable insurance industry has been the adoption of Form N-6 for the registration of variable life insurance policies, and a corresponding amendment to Form N-4, which I'll mention just briefly.

The new Form N-6 focuses prospectus disclosure on essential information that will assist an investor in deciding whether to invest in a particular variable life insurance policy, including information about premiums, death benefits, cash values, surrenders, withdrawals, and loans. The new form minimizes prospectus disclosure about technical and legal matters and improves disclosure of fees and charges.

Many issuers have already filed amendments, as well as new registration statements on the new form. From what we have seen so far - and I am sure this will not surprise anyone - it seems that the greatest difficulty people are having with the form is with the fee table.

In Form N-6, for the first time, variable life insurance prospectuses are required to include a fee table similar to those long required for both mutual funds and variable annuities. Although charges for variable life products are more complex than charges for these other types of investments, it is important that investors receive clear, understandable disclosure allowing them to compare fees and charges among different policies. The N-6 fee table requires that all charges, including rider charges, be disclosed, even though certain charges may apply only to a limited number of policyholders.

The new form also requires that the cost of insurance be presented as a range from the minimum to the maximum charge that may be imposed under a policy. In addition, issuers must include the cost of insurance charges that would be paid by a purchaser who is representative of actual or expected purchasers of the policy. As the Commission stated in the adopting release, we believe that fee table disclosure of the cost of insurance can serve as a flag to prospective investors that this is a significant charge which bears further investigation.

With regard to the treatment of underlying fund expenses, the Commission recently adopted amendments that revise the format of the fee table of Form N-4 to require disclosure of the range of expenses for all of the mutual funds offered through the separate account, rather than disclosure of the expenses of each fund, as was previously required. These amendments, along with some other technical amendments to the fee table, conform the treatment of fund expenses in Form N-4 to that in the new Form N-6 fee table.

The use of a range of expenses for all of the portfolio companies offered through the separate account will simplify the fee table for variable annuity contracts. As with variable life insurance policies, the number of investment options available through a typical variable annuity contract has expanded. In addition, insurers have increasingly offered variable annuity contracts with a variety of unbundled optional features, each of which usually has a separate charge. These trends have caused variable annuity fee tables to become increasingly complicated with the potential for overwhelming investors with information. Disclosure of the range of expenses for all of the portfolio companies offered through the separate account will streamline the N-4 fee table and enable investors to more easily understand relevant information about fees and charges.

Investors in variable annuity contracts will continue to have access to information about the fees and expenses of each portfolio company. In connection with the adoption of Form N-6, we amended Form N-1A to eliminate the exclusion from the fee table requirement for mutual funds that offer their shares exclusively to separate accounts. Because this exclusion has been eliminated, investors in variable annuity contracts will now have access to information about fees and expenses of each underlying fund in the fund prospectus.

B. Advertising

Let me turn now to a current rule proposal that I think is a significant development for the industry. In May 2002, the Commission proposed to amend rule 482 to increase funds' flexibility in advertising by eliminating the requirement that fund advertisements contain only information the substance of which is included in the statutory prospectus. This requirement has resulted in laundry lists and boilerplate statements cluttering fund prospectuses and statements of additional information. This has prevented funds from including timely information in their advertisements, such as information about current economic conditions that normally would not be included in a fund's prospectus. We are hoping that the proposed change, if adopted by the Commission, will make fund advertisements more informative and at the same time streamline fund prospectuses.

The fund advertising proposals also would require that fund advertisements that contain performance information include additional information to provide some context for the performance information, such as the dates during which quoted performance occurred.

The proposed amendments would also require funds that advertise performance to make available -- by a toll-free or collect telephone number -- returns that are current to the last day of the previous calendar month. Fund advertisements would be required to identify the telephone number and, if available, a Web site where an investor could obtain this information. Under existing rules, funds that advertise performance information typically include returns for 1-, 5-, and 10-year periods that are current to the last day of the most recent calendar quarter. Finally, these amendments would reemphasize that fund advertisements are subject to the antifraud provisions of the federal securities laws.

We also took the opportunity of this rule proposal to solicit comments on an issue regarding prospectus delivery requirements for variable insurance products. Rule 482 generally prohibits a fund advertisement from containing or being accompanied by an application to purchase fund shares. There is an exception in the rule that allows a variable product prospectus - which generally constitutes a rule 482 advertisement for underlying funds described in the prospectus - to include a contract application, even though the prospectuses for the underlying funds do not accompany the contract prospectus. Some have suggested that, in light of this exception, it should be permissible for a contract prospectus and application to be accompanied by other types of rule 482 advertisements for the underlying funds that are not part of the prospectus itself.

We think it would be useful to clear up the ambiguity regarding the scope of this insurance exception from the 482 prohibition on account applications, so that variable product issuers may operate with greater certainty. For this reason, we solicited comments on several specific questions related to this issue. We are now actively working towards making a recommendation to the Commission for final adoption of these rule amendments.

C. Proxy Voting Disclosure

I now would like to turn to an important Commission initiative aimed at increasing transparency in the investment management industry and encouraging adherence to fiduciary principles, two elements fundamental to investor confidence. In late September, in response to multiple rule-making petitions, the Commission proposed rules for proxy voting disclosure. The proposed rules would require mutual funds, closed-end funds, and managed separate accounts to disclose to investors their proxy voting policies and procedures, as well as their actual proxy votes cast. The proposal is designed to enable shareholders to monitor their funds' involvement in the governance activities of portfolio companies owned by their funds.

Under the proposal, a fund would disclose its proxy voting policies and procedures in its registration statement, including the procedures it uses when a vote presents a conflict between shareholders' interests and those of the fund's investment adviser, principal underwriter, or its affiliates. Funds' actual proxy voting records would be filed with the Commission and made available to shareholders. If a fund makes a vote that is inconsistent with its policies, this fact would need to be disclosed in shareholder reports. Information on how shareholders may obtain a fund's voting information-through a toll-free number, on its website (if applicable), and on the Commission's website-would also need to be disclosed.

As the Commission noted in the proposal, shedding light on fund proxy voting could illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders' best interests. The comment period for the proposed rules closed on December 6, and we received over 7,500 comment letters on the proposals, the most letters the Commission has received on any investment company rule proposal in recent memory.

D. Portfolio Holdings Disclosure and Shareholder Report Reform

Just last month, the Commission proposed rule amendments intended to improve the periodic disclosure provided by mutual funds regarding their portfolio holdings, expenses, and investment performance. The proposed amendments would require a mutual fund to file a schedule of its complete portfolio holdings with the Commission on a quarterly basis. In addition, the amendments would permit a mutual fund to include a summary portfolio schedule of investments in reports to shareholders, and would allow money market funds to omit the portfolio schedule from its shareholder report, provided that the information is filed with the Commission and available to shareholders upon request.

Together, these proposals would replace a one-size-fits-all approach to portfolio holdings disclosure, where all funds deliver their full portfolio schedules to all their shareholders twice a year, with a "layered" approach that would make more information available while permitting funds to tailor their shareholder reports to their particular circumstances and investors to tailor the amount of information they receive to meet their particular needs. This "layered" approach is intended to result in the availability of enhanced portfolio information at reduced cost.

The proposed amendments would also require funds to include in their annual and semi-annual reports to shareholders a presentation using tables, charts, or graphs that depicts a fund's portfolio holdings by identifiable categories (e.g., industry sector, geographic region, credit quality, or maturity). We believe that this presentation has the potential to effectively convey to investors key information about a fund's investments. Particularly in the case of a fund with a large number of holdings, the combination of a summary portfolio schedule and a tabular or graphic asset allocation presentation could be significantly more useful to many investors than the fund's complete portfolio schedule.

In addition, it is proposed that mutual funds be required to disclose in their reports to shareholders fund expenses borne by shareholders during the reporting period. Under the recommended proposals, fund shareholder reports would be required to include: (i) the cost in dollars associated with an investment of $10,000, based on the fund's actual expenses and return for the period; and (ii) the cost in dollars, associated with an investment of $10,000, based on the fund's actual expenses for the period and an assumed return of 5 percent per year. The first figure is intended to permit investors to estimate the actual costs, in dollars, that they bore over the reporting period. The second figure is intended to provide investors with a basis for comparing the level of current period expenses at different funds. Together, the two expense figures in the proposed disclosure are designed to increase investors' understanding of the fees that they pay on an ongoing basis for investing in a fund.

Finally, the Commission's proposed amendments would require mutual funds to include management's discussion of fund performance, or MDFP, in their annual shareholder reports. Currently, a mutual fund is required to include MDFP in its prospectus unless the information is included in the fund's annual report to shareholders. Mutual funds typically include MDFP in their annual reports, and we believe that MDFP is appropriately located in the annual report with other "backward looking" information, such as a mutual fund's financial statements.

E. Affiliated Transaction Relief

The Commission earlier this week adopted amendments to the rules governing affiliated transactions with registered investment companies. The Investment Company Act contains a number of provisions designed to prevent affiliated persons, who may be in a position to take advantage of their relationship with a fund, from entering into transactions or certain other types of arrangements with the fund, unless the Commission enters an order approving the transactions. The modern fund complex typically includes numerous affiliated persons and entities, including subadvisers, all of whom are constrained in their dealings with the funds under these provisions, even though many of the prohibited transactions involve little potential for overreaching or abuse. The Division of Investment Management issues many exemptive orders approving affiliated transactions each year, which is costly to both the industry and the Commission. For this reason, the Commission adopted a new rule and amendments to existing rules that would codify the relief granted in many of the orders the Division issues each year. They eliminate the need for funds to obtain individual exemptive orders in certain circumstances that we believe are not likely to raise the concerns that the Act was intended to address.

The exemptive rules cover transactions between a fund and its portfolio affiliates. The exemptive rules previously permitted a fund to enter into transactions with a company that is affiliated with the fund as a result of the fund's ownership interest in the company. This type of affiliated person is unlikely to be in a position to take advantage of its relationship with the fund. The Commission expanded these rules to permit a fund to enter into transactions and arrangements with a company that is similarly affiliated with one or more other funds in the fund complex. This is largely a technical change necessitated because the current exemptive rule pre-dated the widespread organization of large fund complexes.

The second area is in transactions with subadviser affiliates. Fund advisers are, of course, also "affiliated persons" of a fund. As a result, an adviser to a fund cannot engage in principal transactions with the fund or any other fund in the fund complex. The SEC has, however, issued a number of orders permitting subadvisers to enter into transactions and arrangements with funds in the complex other than the fund it manages. These transactions involve little potential for self-dealing because the subadviser participating in the transaction is not making investment decisions on behalf of the fund involved in the transaction. Accordingly, the Commission adopted new Rule 17a-10, and amendments to Rules 10f-3, 12d3-1 and 17e-1, to permit these types of transactions without individual exemptions.

V. Enforcement Actions

Finally, I want to mention a few recent enforcement actions concerning variable products.

In June, in only the second SEC action for fraudulent variable annuity switching, the Commission announced the filing of civil fraud charges against Gregory P. Waldon of Redding, California. The suit alleges that Waldon defrauded scores of retired customers by recommending that they replace existing investments in variable annuities with new investments in similar annuities, knowing that the switches would be harmful to his customers but would pay him significant commissions. The complaint alleges that Waldon recommended approximately 57 of these switches between January 1998 and November 2001. The complaint further alleges that Waldon's customers either received no economic benefit or lost money in the switch transactions and together incurred more than $200,000 in needless transaction costs, while Waldon received approximately $275,000 in commissions. The complaint seeks an injunction against Waldon prohibiting future violations of the antifraud provisions of the securities laws, disgorgement of ill-gotten gains, plus interest, and a civil monetary penalty.

Simultaneously, the Commission instituted and settled public administrative proceedings against Donna N. Morehead, who was Waldon's supervisor during the relevant period at one of the registered broker-dealers through which Waldon sold variable annuities. The Commission's Order Instituting Proceedings found that Morehead failed reasonably to supervise Waldon, as she did not investigate adequately red flags raised by certain switches when she reviewed the transactions. Morehead consented to the Order, without admitting or denying the findings. The Commission's Order bars Morehead from association in a supervisory capacity with any broker-dealer, with the right to reapply for such association after one year, and imposes a $10,000 civil penalty.

Meanwhile, in the past two months, the NASD has announced two separate enforcement actions involving sales of variable annuities and variable life insurance policies. Two brokerage firms and one individual were named in disciplinary actions, representing another installment of cases brought in connection with a series of special examinations focusing on the sale of variable contracts conducted over the last several years by NASD.

In the first matter, NASD censured and fined a broker-dealer $350,000 for sales practice and supervision violations in connection with its sale of variable annuities and variable life insurance policies over a 30 month period, ending in 2000. The charges focused on the sale of variable annuities into tax qualified retirement plans and accounts. In making some sales, registered representatives failed to disclose that variable annuities do not provide any greater advantage with regard to tax deferral when purchased in qualified plans. In the sale of a variable annuity to an account that is already tax deferred, sales should only be made when other benefits of a variable annuity such as a death benefit or annuity payout options support the purchase. Some representatives failed to determine that customers had a need for a benefit offered by a variable annuity, other than tax deferral, when recommending the purchase of the product. Such sales were in violation of NASD rules because the registered representatives lacked a reasonable basis for believing that their recommendations were suitable.

In the second matter, a broker-dealer settled charges and consented to the entry of findings that it, through its compliance officer, failed to establish, maintain and enforce adequate written supervisory procedures relating to the sale of variable annuities. Included was the finding that the firm failed to obtain customer information concerning financial status, tax status, investment objectives, and other similar information necessary for making a suitability determination. The firm was censured and fined $75,000, of which $10,000 was assessed jointly and severally against the firm and the compliance officer.

These actions are indicative of the Commission's and NASD's continuing effort to address problem areas in the distribution, marketing and sale of variable products.

VI. Conclusion

Fortunately, variable insurance products and mutual funds have not been found in the recent headlines involving major corporate scandals. But they are an important element in the Commission's efforts to restore confidence in the securities markets. In the Division of Investment Management, we are as busy as we have ever been, focusing on congressionally mandated and Commission-directed initiatives in response to the needs of investors, to ensure access to full, reliable and timely information on which investment decisions are made, and to ensure that the regulatory framework for these products affords comprehensive investor protection, without unduly burdening the industry or stifling innovation.

I hope these comments are helpful to you as you seek to develop a better understanding of variable insurance products. Thank you for listening.



Modified: 01/16/2003