SEC Speech: Integrity and Ethical Standards (P. Roye)
U.S. Securities & Exchange Commission
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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Fostering Integrity and Ethical Standards:
A Prescription for Success
in the 21st Century Marketplace

by  Paul F. Roye

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

Before the Life Insurance Marketing and Research Association,
Life Office Management Association
and Insurance Marketplace Standards Association
Market Conduct Exchange 2000 Conference

Orlando, Florida

November 2, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I. Introduction

Thank you and Good Afternoon. I appreciate the invitation to be here with you today. It is a particular pleasure to be here because of the important mission that the Insurance Marketplace Standards Association, the Life Insurance Marketing and Research Association and the Life Office Management Association have undertaken to promote high ethical standards in the sale of life insurance and annuity products by member companies. I applaud, in particular, what IMSA has been able to accomplish in a relatively short period of time. The number of companies to date that have embraced your Principles and Code of Ethical Market Conduct (240 companies, representing in excess of a 83% market share for individually sold life insurance and variable annuity products in the U.S.), is truly impressive and a testament to the commitment on the part of many insurance companies to develop and implement policies and procedures to promote sound market conduct practices and bolster consumer confidence in the insurance industry. Indeed, fostering confidence in your industry among consumers is critical. Public opinion surveys have shown that of all professionals, brokers and insurance salesmen, rank right down there with us lawyers among the least trusted. We in this room know that there are valid reasons for this view on the part of some. But, we also know that we are on the road to changing these sentiments. Through your organization, you recognize that the ultimate responsibility for ensuring the integrity, fairness and honesty of the insurance products industry rests squarely on the industry's shoulders. You recognize that the industry must take responsibility for good compliance practices and honest and fair dealings with investors. Fulfilling this responsibility is not only good for investors, but it makes good business sense. It will strengthen confidence in the industry and foster continued success.

This afternoon I would like to discuss what I believe are the merits of self-policing efforts like those of your organizations, good compliance practices, the role of the Securities and Exchange Commission and some sale practice areas where we have some concerns. Of course, your business falls within the jurisdiction of the SEC because of your activities with regard to variable insurance products, which are not only insurance but also securities subject to the federal securities laws.

II. Growth in Variable Products

I have been struck by how rapidly the variable product landscape changes. Bonuses, unbundling, enhanced guaranteed minimum death benefits, guaranteed minimum income or accumulation benefits, long-term care riders, flexible withdrawal provisions, and electronic offerings – these concepts that define your products today were unheard of a few years ago.

But when you think about it, that is not so surprising. Assets dedicated to variable annuities and variable life insurance have experienced tremendous growth in recent years. At the end of 1990, the variable products industry had assets of $34.7 billion. As of July of this year, the industry's assets totaled over $821 billion. That's an increase of well over 2,000%.

This growth comes at a time not only characterized by innovative new products, but an increasing number of distribution channels and advances in technology. These changes, of course bring great challenges for the industry, and also for those of us who are responsible for the legal and regulatory compliance aspects of the business. Our challenge at the SEC as regulators, and yours as industry participants, is to honor the principal of investor protection within this environment of rapid innovation and to ensure that this innovation and change benefits not just the insurance industry, but more importantly, investors.

III. Benefits of Self-Regulation

At the SEC, our watchword first, foremost and always, is investor protection. We are guided by the precepts that investors should receive full and fair disclosure about the securities they buy and that those who sell securities should make suitable recommendations. I am pleased to see that these same precepts are embodied in IMSA's Principles and Code of Ethical Market Conduct. IMSA members commit themselves to conducting their business in accordance with high standards of honesty and fairness, through competent and customer focused sales and service, through advertising and sales materials that are clear as to purpose, as well as honest and fair as to content. And just as important, IMSA members commit to fair and expeditious handling of customer complaints and disputes. The self-policing mechanisms that are established in your Code and the implementation of these principles certainly will make the insurance industry stronger.

From our vantage point at the SEC, we do not have to look very far to see the benefits of self-regulation. Self-regulation has been a cornerstone in the securities industry. Indeed, the fundamental principle of self-discipline predates the securities laws. In fact, the old "Shingle Theory" was founded on the principle that, if you held yourself out to the public as offering to do business, you were implicitly representing that you would do so in a fair and honest manner.

Well before the securities laws were adopted, firms had already bonded together to create stock exchanges. By 1934, each of the stock exchanges had a constitution and bylaws, which prescribed collective rules for the admission, discipline and expulsion of stock exchange members. The crash of 1929, however, created a demand for federal intervention to regulate the markets and thereby restore public confidence in them. The Securities Exchange Act of 1934 created the SEC and codified the existing self-regulatory system for broker-dealers. In order to extend the concept of self-regulation to the over-the-counter market, Congress passed the Maloney Act in 1938. This Act provided for the creation of associations of members to assume a regulatory role similar to that of exchanges. The only association that has registered with the SEC to date is the National Association of Securities Dealers, which regulates your broker-dealer operations.

Encouraging an industry to police itself can be more effective than direct regulation. As former SEC Chairman and Supreme Court Justice William O. Douglas said, "self-discipline is always more welcome than discipline imposed from above." He summarized the benefits of self-regulation in an address before the Bond Club of Hartford in 1938 as follows:

"From the broad public viewpoint, such regulation can be far more effective [than direct regulation] … self-regulation … can be persuasive and subtle in its conditioning influence over business practices and business morality. By and large, government can operate satisfactorily only by proscription. That leaves untouched large areas of conduct and activity; some of it susceptible of government regulation but in fact too minute for satisfactory control, some of it lying beyond the periphery of the law in the realm of ethics and morality. Into these large areas, self-government and self-government alone, can effectively reach. For these reasons, self-regulation is by far the preferable course from all viewpoints."

The ability of organizations like IMSA to develop ethical standards that go beyond those which can be imposed by law is an important benefit of self-regulation in the insurance industry, which should redound to the benefit of those who purchase your products. There's a limit to what SEC rules can do. We'll regulate where warranted – but many of the areas that need to be addressed are grey, not black and white, and don't lend themselves easily to rulemaking. That's where you can make a huge difference. In the insurance products area we would like to see a sales culture that considers SEC and NASD rules as merely a starting point – a culture in which we enforce the Minimum standard of behavior, while you insist on the Highest – a culture in which Best Practice becomes Common Practice.

IV. Need for Effective Compliance Systems

While each of IMSA's six fundamental principles of ethical market conduct are important, the requirement to maintain a system of supervision and review reasonably designed to achieve compliance with the other five basic principles is key. This principle requires each member to have a system of procedures and controls in place to maintain compliance with the Code. Hopefully you also have procedures and controls in place that are designed to assure compliance with the law, and the standards the laws impose. With the growth in the variable insurance products industry, it is clear that the industry needs to apply appropriate effort to meet its compliance responsibilities.

An effective compliance system involves two important steps: the first, is obviously to design a good compliance system, but second, devoting the necessary resources to make sure that the system is working. As insurance companies devote more and more resources to new product development and marketing, it is also essential that they devote substantial resources to compliance.

In our day-to-day policing of the industry, we've found that some firms are much better at maintaining high standards than others. The tone set at the top can make a real difference. Individual salesmen don't set company standards, the companies do. Those of you present today that are compliance officers are guardians of those standards. In many cases, it falls to you to serve as the company's conscience. Often, this is not a role that wins popularity contests. Sometimes you must take the unpopular position. But stand apart you must. How else is a firm to know when a judgment is wrong, or a standard too low, unless someone with a clear sense of right and wrong has the courage to question it? We want to help you create an atmosphere that encourages a sales culture that makes the right choices.

Companies today are challenged with the need to oversee far-flung sales forces, selling an ever-growing number of new and complex products. Whether a life insurance company has a captive or independent sales force, or distributes its products through other intermediaries, controls must be in place to prevent sales practices abuses to the greatest extent possible. Effective internal controls to prevent, detect, and correct misleading or abusive sales practices are essential, and will prevent irreparable harm to the company's reputation.

It is your job to make sure that compliance efforts do not fall short of the high standards set by the securities laws and required to inspire confidence among investors. For example, while nothing is inherently wrong with "1035" exchanges – some of which may work to the advantage of customers who receive enhanced products – you need to be sure that these exchanges do not involve churning of policies to generate commissions or the sale of unsuitable products to unwary investors.

V. Suitability Concerns

Several recent press stories have focused on potential problems with the sale of variable annuities to IRAs and other tax-deferred retirement plans. The NASD cautioned members about this practice – in a Notice to Members. The Notice emphasized the fact that variable annuities provide no additional tax deferred treatment of earnings other than that provided by the tax-qualified retirement plan. The NASD stated that sales agents should not only disclose this fact to customers before placing them in a variable annuity investment option for a tax-qualified retirement plan, but also recommend a variable annuity only when its other benefits, such as lifetime income payments, family protection through the death benefit, and guaranteed fees, support the recommendation.

The NASD's approach is right on target. Each time you make a sale, remember that the individual investor's needs and objectives should be paramount.

As many of you know, the SEC staff has been taking a hard look at so-called bonus programs, which offer the investor an immediate credit equal to a percentage of purchase payments. From a marketing perspective, these products have substantial appeal. They offer an investor the opportunity to put his or her entire investment – and then some – to work immediately. According to Cerulli Associates, since 1994, assets under management in bonus annuities have grown at more than twice the rate of total variable annuities.

The question was put succinctly in a recent article in the Hartford Courant when the headline asked "Are Bonus Annuities – A Gift Horse? Or a Trojan Horse? We know, that investors generally pay for bonus credits one way or another, such as higher surrender charges, longer surrender charge periods, and higher asset-based charges. We are concerned by the fact that these charges can more than offset the amount of the bonus. We are also concerned with the potential for sales practice abuses because the cost of the bonus may be less visible than the bonus itself. And our concerns are heightened in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in a "1035 exchange," when an investor at or near the need of a surrender charge period takes on a new surrender charge period as a result of the exchange.

Quite frankly, we are concerned about where the competition among companies offering bonus products will lead us. What are the implications of bonuses increasing from one percent to five percent to six, seven and eight percent or higher? Higher surrender and asset based charges and longer surrender periods will be necessary to ensure that the companies recover the costs of bonuses at these levels. Lets not forget that interests in variable annuities are "redeemable securities". Do these products effectively become "non-redeemable" if upon withdrawal an investor must have his proceeds reduced by a 8.5% sales load, along with the recapture of the bonus? At some point, we may to draw a line in this area to preserve the redeemability feature of these products.

We have been paying close attention to disclosure regarding bonus programs. You can expect us to comment on any presentation of a bonus product that does not fully and fairly disclose the downside, as well as the upside, of the product. To that end, we are asking companies to disclose the cost to investors of any bonus – clearly and upfront.

To address our concerns regarding bonus products, we have been focusing on the suitability of bonus transactions through the Commission's inspections program. We are also working with NASD Regulation to scrutinize sales practices used in marketing variable annuity bonus products. We are pleased that NASDR, as well as IMSA has joined us, in our efforts to heighten attention on bonus products. This past summer NASD Regulation issued a Regulatory & Compliance Alert to assist member firms in ensuring that their bonus product sales material is presented in a fair and balanced manner. IMSA alerted its members and independent assessors to the importance of focusing on sales practices employed in distributing products with bonus features. We applaud your efforts in this area.

The responsibilities of compliance and disclosure must be borne by all participants in the industry. We expect that any firm engaged in the distribution of bonus products will pay particularly close attention to sales of these products, ensuring that adequate safeguards exist to prevent unsuitable sales, and flagging for compliance review any individual sales that appear to be unsuitable. Sellers of bonus products should have comprehensive procedures to guard against sales practice abuses. In this regard, the NASD has issued Notice to Members 99-35, which provides a set of guidelines intended to assist broker-dealers in developing appropriate procedures relating to sales of variable annuity contracts. The NASD encourages the use of an exchange or replacement analysis document exploring the basis for replacing one contract with another. The NASD also suggests that members develop "red flag" procedures that can monitor and identify those registered representatives with a higher rate of variable contract replacements and investigate whether these replacements are unsuitable. If you look at trends in recent SEC enforcement actions, you will see that we are not sympathetic in problematic situations when firms either have no compliance procedures or have compliance procedures but do not implement them.

Again, Former SEC Chairman William O. Douglas described the SEC's oversight role as akin to keeping a "shotgun, so to speak, behind the door, loaded, well-oiled, cleaned, ready for use but with the hope it would never have to be used." Douglas' proverbial shotgun in the closet has to be fired when necessary. You will see a continued focus on sales practice violations by the Commission. Sales practice abuses occur at an investor's point of entity to the market. If investors are defrauded at the door, aside from suffering losses, they are likely to leave and not return. As a result, the Commission has long regarded such abuses – in all areas of the securities industry – as among the most serious violations that we deal with. That's why I was pleased to see that the revised April 2000 edition of the IMSA Assessment Handbook places heightened emphasis upon the need for companies and independent assessors to verify that an insurer's polices and procedures are, in fact, being carried out as intended, at the point of sale.

In recent years, the Commission has meted out tough sanctions in the sales practice area. These include stiff monetary penalties and industry bars for securities professionals. In addition to traditional sales practices abuses involving misrepresentation of risks and rewards, or the characteristics of particular investment vehicles, we will be focusing increasingly on situations involving conflicts of interest. Fraud can occur when a salesperson switches a customer from one fund to another fund or from one variable annuity into another, in order to generate commissions. This summer, we brought a settled administrative proceeding charging that Dean Witter had failed reasonably to supervise a broker who engaged in at least 48 illegal mutual fund switches, including circular switches, in seven different accounts. On September 25, the Commission for the first time instituted proceedings against an investment advisory firm and broker-dealer, for switching involving variable annuities.

Specifically, the principal in the advisory firm is alleged to have induced his investment advisory clients to switch their variable annuity investments by providing them with unfounded, false and misleading justifications for the switches, including false and misleading comparisons of the performance of certain variable annuities and false assurances that the switches would increase the diversification of his clients' portfolios.

As a result of the alleged fraudulent conduct, the Commission is alleging that the clients in this case incurred unnecessary sales charges of more than $168,000, in some cases lost a portion of their investment principal, and that the broker-dealer received commissions of more than $210,000 as a result of this switching activity.

Obviously, this is exactly the type of conduct, which not only we at the Commission, but you in the industry, must guard against and prevent. Let this case be a reminder that we all must be vigilant in policing for this type of practice.

We have been criticized by some in the industry for suggesting that insurers and their principal underwriters have some responsibility to monitor the suitability practices of selling dealers with regard to variable products sales. But insurers cannot act like Ostriches and bury their heads in the sand when it comes to sales practice issues. Inappropriate sales practices not only taint the broker-dealer firm selling the product, but can also cause damage to the reputation of the insurer providing the product. We are pleased that IMSA standards recognized that suitability monitoring is desirable at the insurance company level, consistent with the goal of promoting ethical standards in the industry.

You can expect that the Commission's examination program will continue to focus on the sales and marketing activities of agents and the supervision they receive in the sale of variable products. The inspections staff looks to see if appropriate systems are in place to ensure that agents are asking the right questions to determine the suitability of a variable insurance product, and whether those systems are working.

Obviously, those of you here are concerned about compliance, and by meeting IMSA standards you have made a substantial commitment to an effective compliance program.

VI. Importance of Education

Next, I would like to discuss the importance of education. Education offers another avenue of approach to higher standards in the industry. Investors are best served by sales forces that are continually educated about products, ethics and the law. Many registered representatives have been in the business for a relatively short period of time. If we can reach them with education early in their tenure, we have a chance to make this a better industry for years to come. Your organizations are meeting this need for continuing education.

Finally, I would like to discuss investor education. Chairman Levitt has often asked the securities industry to do more to protect American investors. At the same time, we have also been asking investors to do more to protect themselves. In the last few years, the SEC, working with the securities industry, state regulators, and self-regulatory organizations – has undertaken perhaps the most far-reaching investor education initiatives in its history. Using speeches, radio, television, video tapes, town meetings and the Internet, we have reached a large cross-section of investors and helped them become better informed about the risks and rewards of our markets.

When we began to take a serious look at what we might do in the investor education area, we determined that the Commission needed to fill a gap in its investor education arsenal. Until recently, the Commission had not developed any investor education materials devoted specifically to variable annuities, and we concluded that we should develop a brochure that would address variable annuities generally, including bonus programs.

To that end, we recently designed an investor brochure that describes variable annuities and how they work, and identify various annuity features, as well as their fees and charges. The brochure also cautions investors in areas where we believe caution is necessary – bonus programs, purchases of variable annuities through tax-deferred accounts, fees and charges. The brochure is entitled "Variable Annuities: What You Should Know," and it can be found on our web site at

I also want to acknowledge the industry's recent investor education initiatives. I was very pleased to see the recent introduction of investor education materials on both the ACLI's and NAVA's web sites. Individual companies also are starting to undertake valuable investor education efforts. I was pleased to learn that the Life Insurance Marketing and Research Association has a Customer Assurance Program which surveys customers regarding their understanding of insurance products. While this information should prove useful from a marketing standpoint, it should also be useful in educating investors about your products. We encourage your members, to continue –pursuing these kinds of investor education efforts. Having a well-educated investing public will serve the industry well in the long run. Variable annuities are complicated products; we should do all we can to make them understandable to the average investor.

VII. Conclusion

Today, the variable products industry is a dynamic, highly successful industry, working hard to create products to meet the evolving investment needs of many investors. To retain and improve this position, the industry needs to continue to improve disclosure and maintain a reputation for integrity and fair dealing. Earlier, I referenced the Trojan Horse. In the tale of the Trojan War, the Greeks tried to take over the City of Troy, but its walls were too strong and the army too well-armed. So the Greeks employed an alternate strategy. They built a giant horse, filled it with soldiers and offered it as a symbol of peace. Ignoring the warnings of some against accepting the Greeks strange gift, the people of Troy brought the giant horse inside their walls. The Greek soldiers than emerged and pillaged the city. A brilliant military strategy on the part of the Greeks. In war, there are few rules, and these are often broken. However, in selling securities or variable products, there is no room for the Trojan horse, for misleading or deceiving investors.

In this new millennium, the explosive growth of assets in variable products may make it easy to take investor confidence in these products for granted. In the final analysis, the continued growth and success of the variable products industry will be based on the confidence that the industry's integrity inspires. We are pleased that your organizations have joined with us in this effort to promote the highest market conduct standards. You understand that it's about maintaining the confidence of the pensioner who reads her monthly statement while walking from the mailbox, the firefighter or teacher whose retirement security is dependent on your products. Maintaining their confidence is our collective challenge.

We urge you to continue working with us in partnership toward the common goal of a healthy industry, characterized by full and fair disclosure, the maintenance of high standards and integrity.

Thank you.