finra

Rick Ketchum
Chairman & CEO, FINRA

NAVA Government & Regulatory Affairs Conference
June 8, 2009
Washington, DC

Thank you Catherine [Weatherford, NAVA President and CEO] and Lee [Covington, SVP & General Counsel, NAVA]. I'd like to begin by acknowledging my friend Mark Casady, the extremely effective chairman of the NAVA board, and thanking him for agreeing recently to serve on the FINRA Board of Governors. Mark, my colleagues and I look forward to working with you.

 

NAVA's work has taken renewed importance amid the volatility throughout the financial markets and the U.S. economy, since this volatility coincides also with waves of baby boomers starting to move into retirement. Your initiatives to promote education and understanding of the annuities industry's many products and services are needed more than ever, and your commitment to ensure the highest ethical standards throughout the industry is invaluable at a time of depressed investor confidence. There are a lot of investors with questions about retirement security, and this organization, and its members—all of you here today—can play a valuable role in helping investors to make informed decisions. Given FINRA's focus on investor protection, we will be working to complement your investor education efforts.

 

Needless to say, we are in extraordinary times—the market implosion combined with Madoff resulted in a dramatic loss of investor confidence. The market turmoil, while painful for millions of investors, has created a rare opportunity to pursue comprehensive reforms that will make the financial sector's regulatory architecture more robust.

 

And that process is well underway. The U.S. regulatory system is undergoing its most extensive review since it was created in the late 1930s and early 1940s. This restructuring is by its nature a complex process. But throw in the imperative of rebuilding a regulatory scheme that is comprehensive and thoughtful—yet allows the capital markets to thrive and boosts confidence among investors—and you understand how much work there is to be done.

 

Today, in addition to highlighting recent concerns FINRA has identified with respect to the sales of variable annuities, I want to talk about gaps in financial regulation which have been exposed as a result of the events of the last two years, with a focus on annuities, as well as the disparity in oversight of investment advisers and broker dealers.

 

FINRA

 

But first, let me tell you just a little bit of what is occurring at FINRA, for all regulators must take accountability for the last two years and passionately search for ways to become more effective.

 

After many years of working in the regulatory system, I am proud to join this organization. With a staff of 2,800, FINRA regulates the practices of nearly 4,900 brokerage firms, about 174,000 branch offices and more than 650,000 registered securities representatives, and acts as the primary examiner and rule enforcer for those firms and their employees, under the oversight of the SEC. We are an advocate for investors, dedicated to keeping the markets fair, ensuring investor choice and proactively addressing emerging regulatory issues—hopefully before they harm investors or the markets.

 

Going forward, the fundamental objective of any regulatory reform must be to enhance investor protection. Advancing this objective now takes on even greater importance than usual, given the extreme turmoil in the markets.

 

At FINRA, we've taken a number of actions to enhance investor protection.

 

In early March, we created an Office of the Whistleblower, to encourage individuals with first-hand knowledge of, or material information about, potentially illegal or unethical activity to come forward and share it with regulators. You would be amazed at how the simple action of raising our hand, and creating a centralized investigative unit, has resulted in a wide variety of referrals by us to the SEC.

 

We conducted a comprehensive review of examination and regulatory programs to help us better identify red flags that may indicate fraud. Since learning of the Madoff fraud, we have launched two broad regulatory reviews:

  • custody issues in firms that are registered as both broker-dealer and investment advisers; and
  • the role of broker-dealers as feeders or finders for money managers such as Madoff.

On the latter issue, we've launched a sweep examination to review the type of activity evident in the Madoff scheme. That's just the beginning of where we want to go—we're looking across the organization to coordinate and enhance our regulatory programs.

 

Eliminating Regulatory Gaps

 

Clearly, a key focus of the financial reform initiative today is to address the regulatory gaps that impacted regulatory oversight and market confidence in the last year. While that focus includes needed steps to address OTC derivatives, hedge fund regulation, a proposed national charter for insurance companies and a systemic regulator, I will focus my thoughts on the inconsistencies in sales of financial products. It has long been urged by FINRA—and it is a personal mission of mine—that America's 90 million investors should receive the same level of protection no matter which financial services or products they select. Yet our current system of financial regulation has created an environment in which investors are left without those consistent and effective protections.

 

This leaves many of us asking why the protection you receive depends on the product you buy. Why should it vary depending on whether you work with an investment adviser, a broker-dealer, banker or an insurance agent? We must do better than our current system, which puts the burden on average Americans to make sense of a Rube Goldberg-esque hodgepodge of rules and agencies.

 

Perhaps for this reason, the administration seems to be considering a financial products safety commission, which may be OK in areas like mortgage financing where there has been little previous focus on customer protections. But I have significant concerns in an area like securities regulation—where detailed SEC and FINRA rules and a substantial examination and enforcement infrastructure is in place—that such a system would create significant risks of duplication. Perhaps a better answer is a statutory instruction for minimum standards. We can debate what the basic protections should be, but I think that a rational starting point would be that:

  • every person who provides financial advice and sells a financial product is tested, qualified and licensed;
  • the advertising for financial products and services is not misleading;
  • every product marketed to them is appropriate for recommendation to that investor; and
  • there is full and comprehensive disclosure for the services and products being marketed.

Part of the debate going forward will be to identify which products and services create gaps for investors, and how those gaps should be filled. There will be much discussion about which responsibilities should be allocated among existing regulators and whether new regulatory bodies should be created.

 

Whatever Congress and the administration decide, regulators need to do a better job of working together. FINRA has a strong record of outreach and engagement with fellow regulators, both at home and abroad but we recognize we could do better. We are committed to continuing this cooperation, which is so critical if meaningful reform is to be achieved.

 

The Need for Consistency in Regulation of Annuities

 

Elimination of regulatory gaps is also an issue for the annuity industry. Most of you are very familiar with the confusing situation today.

 

In the case of a variable annuity, FINRA reviews sales material for balance and fairness. The salesperson must pass a licensing exam and participate in continuing education. Disclosure requirements ensure that the investor receives information about the general features of the annuity, including potential surrender charges and periods, tax penalties, and fees and expenses. A registered principal has to approve the purchase.

 

In the case of fixed annuities, the level of protection will depend upon state regulation. In many states, investors will receive detailed information about fees and expenses. In other states, they may not. Suitability and disclosure requirements also will vary, not withstanding the best efforts of NAVA.

 

And the status of indexed annuities is unclear, pending the outcome of litigation challenging the SEC's recently adopted Rule 151A and legislative initiatives to preserve state jurisdiction over indexed annuities.

 

FINRA is certainly prepared to do our part to advance regulatory consistency for annuity products. Over the last few years, we have reached out to the state insurance commissioners to engage in a dialogue to discuss ways to ensure consistent regulatory requirements across all annuity products. We will continue sharing information, though the real goal is to achieve greater consistency in the regulation of different annuity products, as this will foster more effective regulation and improved investor protection.

 

Investment Advisers

 

Another gap in financial regulation that needs fixing is the disparity between oversight regimes for broker-dealers and investment advisers.

 

The absence of a comprehensive examination program for investment advisers impacts the level of protection for every member of the public that entrusts funds to one of those advisers. Indeed, the Madoff episode revealed the risks in having separate regulatory bodies to oversee investment advisers and broker-dealers, especially when these businesses may exist in the same legal entity.

 

The SEC and state securities regulators play vital roles in overseeing both broker-dealers and investment advisers, and they should continue to do so. But it's clear that dedicating more resources to a regular and vigorous examination program and day-to-day oversight for the investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers.

 

As the SEC has noted, the population of registered investment adviser firms has increased by more than 30 percent since 2005. Investment advisers now number 11,300—more than twice the number of broker-dealers.

 

Consider the contrast: FINRA oversees 4,900 firms and conducts over 2,500 regular exams each year. The SEC oversees more than 11,000 investment advisers, but in 2007 conducted fewer than 1,500 exams of those firms—not because of lack of desire but lack of resources. The SEC has said recently that in some cases, a decade could pass without an examination of an investment adviser firm.

 

In recent months, various Ponzi schemes and frauds committed by money managers and investment advisers have underscored the need for additional oversight of investment advisers. The SEC Chairman herself has stated that the agency needs the ability to rely on third parties to get their job done. Regulation by an independent regulatory organization like FINRA, in my opinion at least, would best ensure that investment advisers are properly examined and their customers are adequately protected.

 

There has been a lot of discussion about the difference between the fiduciary standard for investment advisers and the rule requirements, including suitability, for broker-dealers. We agree that this is the kind of issue that should and will be on the table as we all look at how best to reform our regulatory system and strengthen investor protections.

 

In the simplest terms, there's a need to explore seriously whether a properly designed fiduciary standard can effectively be applied to broker-dealer selling activities and, if there are problems raised, make a strong effort to resolve those problems. It is time we make an honest effort to break this logjam—two different standards is simply untenable in this world for persons engaging in very similar activities.

 

But we also believe that the kind of additional protections provided to investors through the FINRA model are essential. The question of whether FINRA should be vested with the authority to regulate investment advisers is ultimately for Congress and the SEC to answer. But from my perspective, FINRA is uniquely positioned to build an oversight program for investment advisers quickly and efficiently.

 

Wealth Event Issue

 

Speaking more generally on our compliance concerns, a key issue we focus on is what I call "wealth events." These are events that happen once or twice in a family's or individual's lifetime. It could be the death of a parent or spouse, severance or simply entering retirement these days. The one thing all wealth events have in common is they involve large amounts of money being turned over and they fundamentally change the way investors interact with their broker or financial adviser, or they may result in a new relationship.

 

When investors finds themselves in such an event, an adviser's first reaction may be to recommend selling everything and starting over, which, of course, generates a lot of commission fees—but may not be the best course of action.

 

That's why I believe the sales practices surrounding these wealth events need to be supervised more closely. They need to be on the radar screen of broker-dealers or investment advisers, not simply as a revenue opportunity, but as a crossroads moment with a client.

 

For these wealth events, variable products obviously may offer a number of attractive investment opportunities. But compliance concerns are raised more starkly as we stand today on the other side of the implosion that has resulted in traumatic investment issues. In this environment, certain characteristics of many variable annuities may raise new concerns.

 

For example, the guaranteed withdrawal benefits in many variable annuities have become a popular feature in recent years. However, as we know, they do present a pitfall for consumers, one that the industry must address. In particular, we are concerned about those consumers who might inadvertently lose their guarantee due to a decline in their account balance. The "no lapse" provisions in the more recently issues contracts will help customers avoid this possibility. However, as you know, even contract holders who have a no-lapse feature in their contract can inadvertently lose their guaranteed payments, if they make an "excess" withdrawal in a single year.

 

The economic downturn has caused some consumers to withdraw cash from their variable contracts. It's to NAVA's credit that their Web site alerts investors to the dangers of excess withdrawals. And, I know many firms provide their customers with various disclosures about the importance of not making excess withdrawals. We expect broker-dealers to provide disclosure that is clear and meaningful. If a customer discusses whether to make a withdrawal with his broker, then the broker must warn the customer of any problems that will occur. Of course, in some cases the customer might go directly to the insurance company, in which case, it is more difficult for the broker to work with the customer on this problem. In that case, we hope that the insurance company will establish effective procedures to warn the customer of the possible effects of excess withdrawals.

 

We are also concerned about the possible replacement of a variable annuity that has an "in the money" guarantee. Of course, we expect firms to rigorously supervise the replacement of any variable annuity. But a variable annuity whose guarantee would offer a higher payout than the cash value of the subaccount presents a particular risk to the customer. Such a customer would lose this benefit if he replaces the product with another variable annuity of an equity indexed annuity.

 

We expect brokers to focus on this issue. Registered principals must be given the information necessary to evaluate a proposed replacement, to ensure it complies with Rule 2821 and with their suitability obligations. The principal must know the value of the guarantee and whether it is "in the money," and must evaluate the comparative guarantees of each product to ensure the replacement is suitable for the customer.

 

More broadly speaking, sales and exchanges of variable annuities continue to be a focus for our examinations. As we stated in our March letter to firms on examination priorities, we are continuing to look at sales and supervision of variable annuities, particularly:

  • recommendations to senior investors;
  • exchanges of variable annuities for equity-indexed annuities;
  • exchanges resulting from a registered representative's change in employment;
  • exchanges based on the perceived financial condition of he issuing insurance company; and
  • supervision of registered representatives.

FINRA will continue to be vigilant in ensuring that firms comply with our sales practice rules in the marketing of variable annuities. Each of your firms must continue to monitor your sales activity to make sure that your representatives are making suitable recommendations and that your firm continues to have robust, up-to-date policies and procedures to supervise these sales and exchanges.

 

As many of you are aware, in 2007 we adopted new Rule 2821, which is designed to ensure that all broker-dealers apply the same standards to their sale of variable annuities, although parts of the rule were delayed to allow us to further evaluate the impact on the industry. In April, the SEC approved proposed amendments to clarify certain aspects of the rule and to address some of the practical issues that firms faced in their implementation of the rule. These amendments will go into effect 240 days after we publish a Regulatory Notice announcing SEC approval, which we expect to publish later this month.

 

I believe that Rule 2821 established a very high bar for the sale and supervision of variable annuities. FINRA listened closely to your concerns about the mechanics of the rule to make sure it worked as efficiently as possible. But most importantly, we never lost sight of the need to protect investors in connection with the sale and exchange of variable annuities. You'll hear more about this later on the FINRA Regulatory Update panel that Stephanie Brown is moderating.

 

Conclusion

 

Going forward, a fundamental objective for everyone operating in and around the annuities industry, as well as the broader financial sector, is the restoration of investor confidence. Thoughtful regulation, and enhanced oversight, will be critical ingredients in the recipe for winning back the trust of investors. But it's just as important for everyone in this industry, and everyone throughout the financial industry, to remember that regulation and oversight alone will not prevent every instance of fraud or deception. What's most important of all is for market participants to act with integrity, and to comply with not just the letter of the laws, but also their spirit. A market imbued with a strong commitment to ethics will breed trust and confidence and enable markets to once again serve as an engine of growth in the United States and throughout the world.

 

This is a great time—a challenging time—a time to step up. I stand enthusiastically ready to work with you to ensure investors are protected. We cannot fail, and together, we can succeed.

 

Thank you.