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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at the 22nd Annual Advanced ALI-ABA Conference on Life Insurance Company Products


Paul F. Roye1

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

Washington, D.C.
November 4, 2004

I. Introduction

Good morning. I am glad to be here, and I appreciate the opportunity to discuss current issues affecting the investment management industry and, in particular, the variable insurance products industry. Please keep in mind 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.

This morning, I would like to discuss issues of concern in the variable insurance products industry, including concerns regarding sales practices and concerns regarding late trading and market timing; ensuring the effective implementation of our new rule initiatives, focusing on several key new requirements; and our efforts to finalize several other pending rule proposals.

This conference comes at a particularly challenging and interesting time for the variable insurance products industry. This past year has been one of the most significant in the history of the investment company industry. For much of the past year, the Commission has focused on pursuing enforcement actions against wrongdoers in the industry and on fashioning an improved regulatory regime to minimize the possibility that we will have serious fiduciary breakdowns in the future.

With regard to the variable products industry, there is the good news that assets in variable annuities alone have now exceeded $1 trillion. In 2003, the variable annuity industry saw the most significant annual percentage growth of net flows in assets in 10 years, up almost 50% over 2002. The National Association for Variable Annuities ("NAVA") reported that although the stock market generally declined from 2001 to 2003, beneficiaries of variable annuity investors received death benefits amounting to $2.8 billion more than the value of the annuities at that time, more than making up for market losses during that time period. According to NAVA, this emphasizes the importance of the guaranteed death benefit feature offered by variable annuities.

But unfortunately, all of the news regarding variable products is not good.

  • In June, a joint report was released by the SEC/NASD regarding broker-dealer sales of variable products noting a large number of complaints from investors, indicating that some investors were sold products that they did not fully understand or a variable product that was not appropriate given the investor's objectives and liquidity needs;
  • Regulators continue to investigate and bring variable products sales abuse cases;
  • For the first time, state securities regulators listed variable annuity sales practices on its list of top ten investment scams;
  • The SEC, states securities regulators and the NASD continue to investigate the extent of late trading and market timing abuses in the variable products area; and
  • Many in the financial press continue to question whether investors should even be purchasing variable annuity contracts.

So clearly, while there is good news for the variable products industry, there are issues that should be of concern to the industry. These issues are certainly of concern to us.

II. Sales Practices in the Variable Products Industry

While the industry must bear the principal responsibility of educating investors about the benefits of variable products, it is clear that one of the key issues that the variable products industry and regulators together have to address is the area of sales practice abuses.

In the past two years, the NASD alone has brought over 80 variable products sales abuse cases and, along with the Commission, is investigating others. These enforcement actions involved excessive switching, misleading marketing, failure to disclosure material facts, unsuitable sales, inadequate written supervisory procedures, failure to maintain adequate documentation and failure to supervise variable product transactions. Those who engage in these practices, tarnish the industry, a majority of whom market their products in accordance with the law. Therefore it is incumbent upon the variable products industry and the broker-dealer community to work with regulators to effectively address this problem.

The NASD is working on a rule proposal tailored specifically to sales of variable annuities that include new sales practice standards, disclosure, supervisory approval and sales training requirements. The rule proposal raises some key questions, including the necessity for a separate risk disclosure statement and a requirement for prospectus delivery before consummation of a transaction.

Many in the industry and industry trade associations have voiced concerns with these potential new requirements. I encourage you to provide your views to the NASD and the Commission as final rules are developed in this area. However, if the sales practice concerns are to be adequately addressed, the industry must do its part. What is the industry prepared to do to address these problems? What will be demanded of the brokers that sell these products? How can insurance company sponsors assert more control over brokers selling variable products? Will insurance companies refuse to do business with firms when there is continuing evidence that their products are being improperly sold. For the well being of the industry, I hope there are appropriate answers to these questions.

A significant component of addressing these sales practice issues is making sure that investors receive appropriate disclosure regarding the conflicts and compensation of those selling funds and variable products. The Commission has proposed significant revisions to the form and content of broker-dealer confirmations regarding transactions in fund shares and variable insurance contracts, and also proposed a new point of sale disclosure document for broker-dealers. Together, these two proposals would greatly enhance the information that broker-dealers provide to their customers in connection with mutual fund and variable contract transactions. They would also highlight for customers many of the conflicts that broker-dealers face when recommending certain investments, such as commissions and revenue sharing arrangements. The enhanced disclosure, therefore, should have the further effect of enhancing the accountability of broker-dealers to their customers when making recommendations for a particular fund or variable contract. Our Division of Market Regulation is busy analyzing the comments on these proposals, working with focus groups of investors and crafting a final recommendation to the Commission.

III. Late Trading and Market Timing in Variable Products

The past year has brought to light a number of troubling abuses in the fund industry, most notably arrangements to permit late trading and abusive market timing. By last count, the Commission over the past 14 months has brought 51 enforcement cases related to the mutual fund scandals and levied $900 million in disgorgements and $730 million in penalties. The facts alleged in these cases reveal a lack of concern for investors' interests that cannot be tolerated in a responsible industry built on fiduciary principles. Sadly, too many mutual fund industry participants, including intermediaries that distribute fund shares, were willing to betray investor trust in order to make a quick buck or advance the interests of their firms over those of their investors.

The Commission, the states and the NASD are continuing our investigations into late trading and abusive market timing. In August, the Commission brought the first enforcement action charging insurance companies with securities fraud for facilitating market timing of mutual funds through the sale of variable annuities. In settling that action, the insurance companies agreed to a total payment of $20 million in disgorgement and penalties as well as undertakings of compliance reforms. The insurance companies also agreed to undertake operational reforms and other compliance measures, including the hiring of an independent consultant to review compliance procedures designed to prevent and detect market timing.

The Commission's Order found that the prospectuses through which the insurance companies sold the variable annuities misleadingly represented, among other things, that the annuities were "not designed for professional market timing organizations." However, the insurance companies affirmatively marketed and sold the annuities to professional market timers. Eventually, market timing assets constituted the majority of assets invested in their variable annuity products.

In a separate action, the NASD in June brought its first ever case against a broker-dealer for facilitating deceptive market timing in variable annuities. The NASD also found that the firm failed to establish and maintain a reasonable supervisory system and written supervisory procedures designed to prevent the late trading of mutual funds. The NASD fined the firm $450,000 and ordered it to pay more than $288,000 in restitution to the affected funds. Under the facts involved in this case, the broker-dealer allegedly helped two hedge funds carry out deceptive market timing in the sub-accounts of variable annuities. The broker-dealer also allegedly routinely received trading instructions from customers after 4:00 p.m. and executed those trades as if the instructions had been received prior to 4:00.

Needless to say, these cases are troubling. Unfortunately, these cases may not represent all of the wrongdoing related to the late trading and market timing in the variable product context. The Commission, the states and the NASD are continuing to investigate late trading and abusive market timing in variable products, and there are likely to be more cases brought in this area.

IV. Implementation of a New Mutual Fund Regulatory Regime

Under Chairman Donaldson's leadership, the Commission this past year has undertaken an aggressive mutual fund regulatory agenda that has focused on four main goals: (1) addressing late trading, market timing and related abuses; (2) improving the oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) addressing or eliminating certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) improving disclosure to fund investors, especially fee-related disclosure.

The work we have accomplished on Chairman Donaldson's mutual fund reform agenda represents a comprehensive effort to strengthen investor confidence in the investment management industry. However, as Chairman Donaldson stated recently, "Rulemaking alone cannot reform an industry. An industry must be motivated and committed to reforming itself." That is why your role in implementing the new rules is so critical. Your focus and attention to the effective implementation of the new rules is essential to ensuring that the new rules achieve their investor protection goals.

However, we understand that the responsibility for implementing the new rules cannot fall to the industry alone. The proper application of our new regulations in the variable products context is challenging in some cases. In this regard, we stand ready to help you. As Chairman Donaldson recently commented,

It is in our interest, and the interest of fund investors, to ensure that our new rules are implemented in a meaningful way. We want to work with you, and answer your questions, as you continue to implement the rules. Together - and I emphasize the word together - we can restore investor confidence.

So now let me discuss several of the key rules that you are undoubtedly focusing on.

A. Compliance Rule

Last month, we passed a historic date for the investment management industry: the October 5th compliance date for the new compliance policies and procedures rule, which also includes the new chief compliance officer requirement. The importance of this new rule cannot be overstated, and many industry observers believe that the rule will in time prove to be one of the most significant of the industry reforms the Commission has put in place over the past year. There can be no doubt that the role of the chief compliance officer underscores the importance of internal attention and focus on compliance at investment management firms and insurance companies issuing variable products.

Compliance is about more than creating a thick binder full of comprehensive written policies and procedures. While the development of policies and procedures is an important first step, it is just that: a first step. Now comes the hard part-implementing your recently updated or newly adopted compliance policies and procedures.

On this point, I have a few pieces of advice. First, pay attention to detail. The breakpoints situation, in which a large number of investors did not receive the front-end sales load breakpoint discounts to which they were entitled, in many ways was a failure to pay attention to the details of stated policies and procedures. As we learned from that example, details cannot be glossed over. In addition, when you make a promise to investors, you better have the systems and procedures in place to ensure that the promise can be met. Compliance procedures are meaningless if they are not enforced. We envisioned the compliance officer not only as the primary architect and enforcer of compliance policies and procedures, but also as the eyes and ears of the board on compliance matters. All too often in the Commission's recent enforcement cases, we have seen fund directors denied information about compliance matters. The rule will change this as a compliance officer reports to, and is accountable to, the fund's directors or, in the case of the compliance officer of a separate account, the insurance company personnel responsible for oversight of the separate account's operations.

Second, test your policies and procedures. Make sure they are working. A fund's compliance policies and procedures should be designed to accomplish three goals: (1) prevent violations of the securities laws, (2) detect violations when they occur, and (3) promptly correct violations that have occurred. Don't ease up on your compliance efforts now that your procedures are in place. I strongly recommend that you periodically test your procedures to ensure that they are working and that investor protection is not being compromised. I further encourage you to analyze information over time in order to identify unusual patterns that may point to compliance problems or deficiencies.

Third, don't allow exceptions to your compliance policies and procedures to compromise their effectiveness. As we saw in the recent scandals, some firms had policies and procedures in place, but undercut the effectiveness of those policies and procedures by permitting exceptions that were not in the interests of a fund's investors. Our inspections staff is sensitized to this issue and will be asking probing questions about the exceptions that are allowed under your compliance policies and procedures, who is authorized to approve any exceptions and whether a fund's board is notified of exceptions to the fund's compliance procedures.

With respect to the new role of the chief compliance officer, I want to emphasize that we view the chief compliance officer as our partner in the protection of investors, not our adversary. We look forward to working with those of you in the audience who are serving as chief compliance officers of funds, separate accounts and advisory firms. It is a critical function, and we want to make sure that you have the support you need from the SEC. We are actively considering ways to ensure regular communications with compliance officers to alert you to new developments and areas of concern. We welcome your ideas in this regard.

B. Disclosure Regarding Market Timing Policies, Fair Valuation and Selective Disclosure

Another of the Commission's new rules that you are very likely focused on right now is the new required disclosure regarding a registrant's policies and procedures regarding frequent transfers of contract value among underlying funds. This new disclosure is required for any fund or variable product issuer filing a registration statement, or an amendment to its registration statement, on or after December 5th. The Commission purposely picked this date- which is two months from the October 5th compliance rule date-on the theory that funds and their boards, as well as insurance companies, would have reviewed, updated and approved their procedures and be in a position to provide good disclosure about them two months later.

Under the new rules, fund and separate account prospectuses must state the risks that frequent transfers of contract value may present to investors, if any; whether the fund's board or the separate account's depositor has adopted policies regarding frequent transfers of contract value and if not, why not; and describe policies and procedures for deterring frequent transfers. In preparing this new disclosure, you should seek to make sure that the disclosure provides an appropriate level of specificity so that it is meaningful for investors.

I want to point out that, under this new disclosure requirement, variable product issuers do not have to disclose policies and procedures for detection of persons who may be violating their frequent transfer policies. The Commission did not want this type of disclosure to provide a road map to market timers. This position represents a change from the proposal in response to concerns expressed by commenters. However, I think you can expect examination staff-when they come in-to ask what practices you use to detect market timing, how they are employed and who is responsible for them.

In addition to the enhanced disclosure regarding frequent transfers of contract value, the Commission required enhanced disclosure of a fund's (and a management separate account's) use of fair value pricing. I would point out that the Commission has made clear that it believes that fair value pricing is an important ingredient in combating market timing. Fair value pricing is required under the Investment Company Act, and Chairman Donaldson has asked the staff to explore ways in which we could provide additional guidance to the fund industry in meeting its fair valuation obligations.

The new disclosure requirements also require disclosure of the policies and procedures regarding when a fund, or a management separate account, or their respective service providers may selectively disclose portfolio holdings. I urge all fund personnel to pay particular attention to this issue to ensure that they do not inappropriately divulge portfolio information either purposefully or inadvertently. Communications between a fund and an insurance company that offers the fund as an investment option should also be reviewed for compliance with the fund's stated policies in this area.

V. Finalization of the Commission's Mutual Fund Reform Agenda

Just as you are working to implement the new rules that have fast-approaching compliance dates, the staff of the Division of Investment Management is working hard to make final recommendations to the Commission on two outstanding rules proposed as part of Chairman Donaldson's mutual fund reform agenda: the hard 4:00 proposal and the 2% redemption fee.

A. Hard 4:00 Close

Last December the Commission voted to propose what has come to be called the hard 4:00 close. Under the proposal, all fund purchase, redemption and exchange orders would have to be received by a fund, its designated transfer agent or NSCC by 4:00 p.m., east coast time to get that day's price, rather than merely received by a fund intermediary by 4:00 p.m., as is permitted now.

I would point out that the proposed rule essentially leaves unchanged the current operations of registered variable product separate accounts with regard to transactions in underlying fund shares. As long as an insurance company receives an order for a registered variable product by 4:00 p.m., the order will receive that day's price, even when the orders are not submitted to the underlying funds until later. However, the rule as proposed would change the ability of an unregistered separate account to submit fund orders after 4:00. Similarly, the rule would affect the operations of insurance companies and their affiliates serving as fund intermediaries in their role as retirement plan administrators. We have received and are considering several thoughtful comments from participants in these markets.

We believe that this rule would provide for a secure pricing system that would be highly immune to manipulation by late traders. It would substantially narrow the universe of those who are accountable for the timing of fund orders and better enable examiners to monitor compliance with the 4:00 p.m. cut-off restrictions. Many of those commenting on the proposal oppose this approach, particularly the intermediaries who would no longer have until 4:00 p.m. to accept orders for fund transactions as they currently do. They argue that it will require some intermediaries to have cut-offs for orders well before 4:00 p.m. and limit investor opportunities to place orders for fund transactions.

Some have suggested alternatives, noting for example that available technology could permit unalterable time stamping of transactions that could ensure the effective verification of compliance by intermediaries selling fund shares. On the other hand, many intermediaries stated that they would have to invest significantly in systems upgrades, if a hard 4:00 rule was adopted. In addition, commenters raised significant concerns regarding the impact of a hard 4:00 rule on investors in 401(k) plans and similar vehicles that may have difficulty achieving same-day processing of mutual fund orders in a hard 4:00 environment.

In response to the concerns of commenters, the staff is reviewing the technological capabilities of retirement plan administrators and other service providers and fund intermediaries so that we can obtain a more complete understanding of various systems issues and alternatives to a hard 4:00 rule. The staff also is examining the suggested approach of imposing procedures and controls on the acceptance and cancellation of fund trades, combined with an independent annual audit of the procedures. In addition, we are considering the extent to which there are tamper-proof time-stamping systems.

The staff is analyzing these approaches to determine whether there is an effective alternative to the hard 4:00 rule proposal that would not disadvantage certain investors and would not distort competition in the marketplace. A challenge for the staff is that any rule that the Commission adopts in this area potentially may have significant implications for order processing systems and costs. Thus, we need to consider the financial and systems impact of our approach, while at the same time keeping an eye on our goal of eliminating late trading.

B. 2% Redemption Fee Rule

Earlier this year, the Commission proposed a mandatory 2% redemption fee for investors that redeem their shares within five business days of their purchase. The purpose of the rule would be to allow funds to recover the administrative costs of rapid trading and help deter abusive market timing. Importantly, a redemption fee is paid to a fund, for the direct benefit of a fund's investors, rather than to a fund's manager or other service providers, or to the insurance company.

Aside from some mutual fund industry commenters, most commenters opposed the mandatory 2% redemption fee rule. However, based on our market timing reviews and examination findings, there is a strong indication that imposition of a redemption fee can have a positive effect on deterring market timing. Consequently, the staff is trying to weigh the advantages and disadvantages of a mandatory versus a voluntary approach to imposition of redemption fees. If voluntary, the decision of whether to impose a redemption fee would essentially be left to fund boards to decide on a fund by fund basis. Many people believe that boards are in the best position to determine whether a redemption fee is appropriate for their individual funds and their investors.

Insurance companies commenting on the proposal have underscored the difficulty of implementing several divergent redemption fee policies adopted by the various fund groups they offer. Some of you have expressed concern that the proposed rule may raise significant legal issues under existing variable annuity contracts and variable life policies. You have pointed out that state insurance laws require that variable contracts specify maximum and guaranteed charges and pricing formulae under the contracts. In addition, contract provisions detail limitations and/or charges applicable to transfers among subaccounts. Although we are not aware of an insurance company having been sanctioned by state regulators or found by a court to be in breach of contract or otherwise liable for facilitating the collection of a fee by an underlying fund, we are evaluating these comments, as we prepare a recommendation to the Commission for a final rule.

I should note that the 2% redemption fee was never intended by the Commission to be a comprehensive or complete solution to the problem of abusive market timing. As I mentioned, the Commission has stressed the importance of fair value pricing in reducing the profit that many market timers seek. When proposing the redemption fee rule, the Commission asked for comment on additional guidance that could be provided to firms with respect to fair valuation. Consequently, we are considering whether the Commission should also issue an interpretive release or other guidance to assist funds with their fair valuation obligations under the statute.

VI. Reassessment of Commission Effectiveness

One of Chairman Donaldson's goals has been to strengthen the Commission's role as the investors' watchdog. He has undertaken a comprehensive review of every division of the Commission--assessing current needs, resources, reviewing methodology and installing performance measures. I should note that, as a result of a budget increase and this review, the Commission has been able to increase its examination staff by a third to approximately 500 examiners in the investment management area. With increased staff, and new examination protocols, we have enhanced our ability to detect violations of the law.

Additionally, the Chairman has created a new Office of Risk Assessment, which is focused on early identification of new or resurgent forms of fraudulent, illegal or questionable behavior. The Division of Investment Management has established its own risk management group that reports into and works closely with the Office of Risk Management. Chairman Donaldson has also formed task forces whose mission is to prepare the outlines of a new mutual fund and investment adviser surveillance program. These task forces are rethinking the mutual fund and investment advisory reporting regimes considering both the frequency of reporting to the Commission and the types of information that should be reported to the Commission to facilitate oversight of the industry. We are also considering how technology can be used to enhance the ability of the Commission in carrying out its oversight responsibilities. Under Chairman Donaldson's leadership, the Commission is taking significant steps to improve and enhance its watchdog function.

VII. Conclusion

In conclusion, the Commission continues to be committed to establishing a regulatory framework for mutual funds and variable products that best serves the interests of investors. A top priority for the Commission and the staff is working with the industry to ensure effective implementation of our new rules.

We look forward to continuing to work with you, and appreciate the effort and dedication that you have put in to revamping your internal processes and procedures-and your public disclosures. These are important efforts to strengthen the trust and confidence of America's investors in funds and in variable insurance products. We still have more work to do, however. And I encourage you to continue your efforts and vigilance.

Thank you for listening, and I hope you enjoy the conference.



Modified: 11/05/2004