Speech by SEC Staff:
Remarks before the ALI-ABA Variable Insurance Products Conference
Chief Counsel, Division of Market Regulation
U.S. Securities and Exchange Commission
November 5, 2004
Within the past year, we have fielded a number of inquiries from the bar regarding various sales programs for variable insurance products. Given the high level of interest regarding whether and how broker-dealers may sell variable insurance products to customers on credit, particularly in the area of premium financing for variable life products, I would like to discuss with you today the applicability of Section 11(d)(1) of the Exchange Act to credit transactions in variable insurance products. But before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.1
When analyzing whether a broker-dealer can sell a particular variable insurance product on credit to a customer, we must look first to Section 11(d)(1). This provision of the Exchange Act generally makes it unlawful for a person who acts as both a broker and a dealer to effect -- and I'm quoting from the statute here -- "any transaction in connection with which, directly or indirectly, he extends, maintains, or arranges for the extension or maintenance of credit to or for a customer on any security (other than an exempted security) which was a part of a new issue in the distribution of which he participated as a member of a selling syndicate or group within 30 days prior to such transaction." Section 11(d)(1) prohibits the extension of credit in connection with the original sale of the new issue security, and it also prohibits the security from being used as collateral in connection with other credit transactions that the broker-dealer may effect for a customer within the 30-day period.2
Over the years the staff has received a number of interpretive questions regarding Section 11(d)(1). One of the preliminary questions stems from the fact that Section 11(d)(1) applies only to a person that is both a broker and a dealer. The staff has taken the position that a person does not have to be a broker and a dealer in the same issue of securities for 11(d)(1) to apply.3 Thus, if a person acts as a broker only with regard to a particular new issue of securities, but also acts as a dealer in any other issue of securities, Section 11(d)(1) would apply to any credit transaction on the new issue effected by that person.
Next, for Section 11(d)(1) to apply, a "new issue" of securities must be involved. In this context, "new issues" generally are securities being sold or distributed for the first time. Because open-end mutual funds (open-end investment companies and UITs) continuously offer their shares for sale to investors, they are "new issues" for purposes of Section 11(d)(1).4 In a typical variable insurance product, some portion of the premium payments are directed to a separate account that is registered under the Investment Company Act, usually as a UIT. Because the policyowner is being issued an interest in the separate account and such interest did not exist prior to its issuance, each sale of such a product involves a "new issue." A variable insurance product sold on a single premium basis would similarly be considered a new issue because it would constitute the first time that the security was being distributed. In a program involving a variable insurance contract in which the policyowner makes payments toward the variable insurance product over time, such as flexible premium variable life, each premium payment would also constitute a new issue because each payment involves the issuance of a new interest in the separate account.
After finding that a new issue is involved, you must then determine whether the broker-dealer participated in the distribution of the new issue as a member of a selling syndicate or group. The Commission has taken the position that a broker-dealer selling mutual funds either as a distributor or as a retailer is a member of a selling group.5 The same logic applies to broker-dealers selling variable insurance products as a distributor or retailer.
Once you determine that the entity is both a broker and a dealer, that a new issue is involved, and that the entity participated in the distribution of the new issue as a member of a selling group, there must be an extension of credit on the new issue for Section 11(d)(1) to apply. The staff has taken the position that any time a customer buys a variable insurance product and does not pay the full premium in cash or fully collateralize the purchase, an extension of credit has been made.6
While it is easy to determine whether a broker-dealer has directly extended or maintained credit, assessing whether a broker-dealer has "arranged" credit involves a more detailed, fact-intensive analysis. The guiding principle with regard to the arranging limitation in Section 11(d)(1) is that a broker-dealer cannot arrange for its customer to obtain financing to purchase a new issue if it could not have extended the credit directly.7 In other words, a broker-dealer cannot get around the prohibition of Section 11(d)(1) by simply arranging for a third party to provide its customer with credit in a situation in which the broker-dealer would be prohibited from extending such credit itself.
This leads to the question of how much a broker-dealer can do in terms of helping a customer obtain financing for a transaction involving a new issue sold by the broker-dealer without violating the Section 11(d)(1) prohibition against "arranging." The Commission's decision in Sutro Brothers & Co provides general guidance regarding what constitutes impermissible "arranging."8 In that decision, the Commission set forth the general principle that a broker-dealer will have engaged in impermissible arranging of credit whenever it performs "some act without which the credit would not be supplied." Whether a particular set of facts would violate the general principle set forth in Sutro involves a detailed factual analysis. Given the limited time I have here today, I will not attempt to parse through any particular sets of facts that would or would not constitute "arranging," but I would encourage any of you to contact the staff if you have specific inquiries in this area.
Now some of you may be wondering why I am talking about the Sutro case, since it involved violations of the "arranging" provision of Regulation T, and not Section 11(d)(1).9 The reason is that the Commission has historically interpreted "arranging" under Section 7(c) and "arranging" under Section 11(d)(1) in tandem.10
The questions we have received regarding how Section 11(d)(1) applies to various "arranging" fact patterns seem to all stem from a fundamental misunderstanding of the extent to which Section 11(d)(1) was affected by the Fed's amendment of Regulation T. You should know that Exchange Act Section 11(d)(1) and the federal margin regulations promulgated under Exchange Act Section 7 have very different purposes. Congress enacted Section 11(d)(1) in an effort to deal with the inherent conflict of interest that exists when a person acts as both a broker and a dealer of securities. At the time, Congress contemplated a complete separation of the broker and dealer function in order to deal with conflicts of interest considered potentially detrimental to investors. One such concern was firms selling new issues of securities to customers on credit when the firm was also participating in the distribution of the new issue.
Rather than completely separating the broker and dealer functions, Congress implemented certain prophylactic measures to deal with the potential conflicts. They enacted Section 11(d)(1) to deal with the conflict of interest that exists when a person has new issues to distribute while, at the same time, he is acting as a broker selling securities to customers. Thus, the focus of Section 11(d)(1) is on new issues of securities that are in distribution.
In contrast, Exchange Act Section 7(c) by its terms applies to "any security (other than an exempt security…)" and makes no reference to either "new issues" or distributions of securities. Thus, the margin regulations the Fed promulgated under Section 7 cover a broader range of securities transactions than Section 11(d)(1). In its 1979 study of federal securities credit regulations, the Federal Reserve Bank of New York stated that, "inhibiting fluctuations in securities prices must be accepted as the leading contemporary goal of the margin regulations."11 The New York Fed also stated that "a very important goal of securities credit regulation is protecting creditors from adverse customer credit risks and protecting customers from creditors who go into default while holding collateral belonging to customers.12" In addition, the Senate stated in its report accompanying the Exchange Act that Section 7 was designed in part to address investor protection concerns relating to the pitfalls of investing in securities on too thin a margin.13
Thus, Section 11(d)(1) and the margin regulations have different, although somewhat interrelated, purposes. Section 11(d)(1) was designed to apply only to new issues in distribution and to deal with potentially harmful extensions of credit by broker-dealers to customers. The margin regulations were designed to provide protections against fluctuations in the securities markets as a whole while providing broker-dealers with protections against excessive credit exposures and customers with protections against broker-dealer insolvency stemming from credit exposures while providing collateral benefits by protecting investors from investing in securities at unsafe margin levels. Thus, consistent with its more limited focus on investor protection, Section 11(d)(1) continues to prohibit arranging for the extension of credit on new issues, even in circumstances in which the extension would be permissible under Regulation T.
One of the primary concerns with regard to broker-dealers extending credit to customers on mutual fund shares is the fact that mutual fund shares are often sold with sales loads or charges that are significantly higher than commissions charged for transactions in other securities. In 1984 when the Commission adopted Rule 11d1-2 under the Exchange Act, it noted this concern in particular in declining to adopt a rule that would allow broker-dealers to sell mutual fund shares on margin or to extend, maintain, or arrange credit on mutual fund shares held by customers for less than 30 days.14 The concern is that sales loads and other sales compensation, whether they are assessed upon sale or deferred, provide broker-dealers with an improper incentive to extend credit to customers on fund shares. Because variable insurance products are normally sold with sales charges as well as contingent deferred sales charges that exceed normal sales commissions on operating company shares, there remains a concern that such sales compensation could provide an improper incentive for a broker-dealer to extend credit in order to facilitate the sale of such products. As such, I believe that Section 11(d)(1) continues to provide an important sales practice protection for investors by addressing the conflict of interest that exists when a broker-dealer sells variable insurance products with high sales charges and/or redemption fees.
In conclusion, Section 11(d)(1) continues to be generally applicable to the sale on credit of variable insurance products, including premium financing programs for variable life products. Whether a broker-dealer has "arranged" for the extension or maintenance of credit on a variable insurance product depends on the particular facts involved, and in that regard, the general "arranging" standard set forth in Sutro should be read broadly. Finally, it must be kept in mind that a particular arranging activity could be lawful under Regulation T, but violate Section 11(d)(1).
This discussion expresses my views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.