finra

Remarks by Susan L. Merrill
Executive Vice President, Chief of Enforcement

NAVA Conference

Washington, DC

June 3, 2008

 

Thank you for that kind introduction. It's a pleasure to be here with you this morning.

Two weeks ago, I had the opportunity to speak at the Museum of Financial History. The event was part of a two-day program where financial journalists were able to visit with and sit in on briefings from most of the Manhattan-based broker-dealers, the NYSE, Nasdaq and regulators.

After my presentation was over I took a few questions from the press. There were about 30 reporters there and do you want know what the FIRST question was? They asked me, "Why haven't variable annuities been eliminated by regulators given their long, serial history of abuse?"

Unfortunately, this question didn't just come out the blue.

It's an issue that was on reporters' minds because, frankly, the sale of variable annuities has raised a lot of question over the years. It's a product that—due to suitability issues—has caused harm to some investors and serious questions have been raised over the tactics used to market them.

I'll tell you my answer to that reporter's question at the end of my remarks, but before I do I'd like to give a brief update about what we have been doing over the last year since forming FINRA in July. Then I'd like to talk about some of the issues we're focused on at FINRA surrounding variable annuities, particularly suitability and disclosure issues.

Consolidation Update

I'm pleased to report that we have made significant progress integrating NASD and NYSE regulatory operations. The transformation of FINRA's enforcement department is now complete. We have integrated 300 investigators and attorneys in 15 offices across the country, from New York to California, Chicago and Dallas. We've taken pains to ensure that no matter where you encounter FINRA Enforcement—and I know you hope you never do—we will be speaking with one voice, consistently applying the way we interpret the rules and the credit we give to a firm or an individual for cooperation. The integration of the two arbitration departments is also complete—resulting in one forum for all new arbitration cases.

Technology integration is also moving ahead. Our goal is to have FINRA's full suite of technology applications integrated within 24 months, and we feel comfortable about our ability to achieve that goal.

Our integrated exam program is also now up and running. Before, each organization's exam program had different strengths, and slightly different approaches. So in our unified exams you will see a process with some significant changes and improvements.

For the first time, there is one team of FINRA examiners for each exam. They may conduct reviews of different areas—such as financial operations or sales practices—but just one team coordinates all information requests and conducts one opening meeting—and one exit meeting—with firm management and ultimately issues one Exam Report.

Firms are typically advised of upcoming exams as much as 30 days before fieldwork begins. This doubles the historic 15 days advance notice provided for N-A-S-D exams.

The new FINRA exam program is also more risk-based—and better able to take into account the scale and scope of each firm's operations. In addition, the exam closing process has been enhanced and includes opportunities for firms to review and explain exam findings with FINRA staff.

But at the heart of the consolidation is the new, single rulebook.

Merging the two rulebooks that have governed a diverse securities industry is a complex process and it will take some time.

As part of the process to develop a consolidated rulebook, we have conducted a comprehensive review of all existing NASD and incorporated NYSE rules. We've categorized them into three groups: rules that can remain unchanged, rules that are obsolete or duplicative that we will recommend eliminating, and rules that would benefit from being revised and/or rewritten.

Some of these rules may be renumbered and reorganized into a more logical and more user-friendly framework, yet will remain unchanged in substance. This move is part of our effort to better organize rules along subject matter lines to bring the benefits of consolidation to the industry.

The next steps will be more difficult. Rules that need to be amended or rewritten will be analyzed with an eye toward whether a more "tiered" approach should be applied based on a firm's size or its business model.

We've issued regulatory notices seeking comment on four proposals for the new rulebook. The four areas are: Financial Responsibility, Supervision, Books and Records, and Investor Education and Protection.

We've also submitted directly to the SEC a proposal to move NASD marketplace and procedural rules into the new FINRA rulebook without any material changes, except renumbering and reorganizing them into a more user-friendly format.

The Board will continue to review tranches of rules over the coming months as we continue to build the FINRA rulebook, and you will see them on a rolling basis as they are published for comment.

As always, I encourage you to let us know your thoughts while these rules are open for comment.

The SEC, of course, must approve FINRA rules before they become effective-and as we set effective dates, we will remain sensitive to the practical issues firms face in implementing rule changes.

Variable Annuities: Trends and Issues

Now let me turn to variable annuities and the question posed by that reporter—"Why not just do away with them?"

Some of you may think that the Chief of Enforcement would join in on the pummeling of variable annuities, but as a matter of fact, I won't. I believe there is a place in the market for these products, to help address longevity risk that new retirees will increasingly face.

However, as that reporter's question illustrates, these products certainly have received their fair share of bad publicity. Yet, despite this sometimes negative attention, brokers keep selling them and people keep buying them. Last year, a record $184 billion worth of variable annuities were sold.

But they aren't for everyone. Studies have shown that 48 percent of all cases of "senior investment exploitation" from 2005 - 2006 involved variable or equity-indexed annuities. In 2004 that number stood at 34 percent—that's a 14 percent increase.

Now, again, I'm not here to bash variable annuities. But I am here to send a very clear message: FINRA is watching very closely how variable annuities are being sold to the public—and for good reasons.

For one, the target audience for annuities—people preparing for retirement—is about to take off.

The numbers speak for themselves. Over the next 20 years, 75 million Americans will turn 60. That represents 10,000 new 60-year-olds every day—and they're going to be looking for investment advice.

Interacting with seniors is one of the most important issues the securities industry, as well as individual brokers, will face in the coming years.

FINRA has been stressing to firms and their representatives their obligation to deal with senior customers in an honest and open manner.

Last September, we issued a Regulatory Notice that highlighted a wide range of issues for firms to consider when dealing with seniors.

Before any product is sold to a senior, it must be determined to be suitable for that individual. Firms should train their reps and insist that they ask detailed questions to find out how much income the customer needs to meet common expenses such as a mortgage, health care needs and long-term care.

They also need to work closely with the customer to determine how important it may be to keep their investment liquid in case emergency or short-term needs arise.

Given the unprecedented number of investors who are at or nearing retirement age, protecting investors is a FINRA priority and we urge firms to make it a priority too, particularly when variable annuities are involved.

Unfortunately, not all firms have made it a priority.

Let me cite one case that highlights many of the potential problems posed by variable annuities-specifically, lax suitability supervision and the practice of encouraging investors to switch out of one annuity into another one when it's not necessary and, in fact, may be detrimental to their financial interest to do so.

Why? There's no question that when a broker earns high commissions, it can help drive sales. Brokers have the right to make a living, but when making money leads firms and brokers to give bad advice, and make unsuitable sales, it's simply unacceptable.

Sometimes, to earn that commission, brokers convince customers to switch out of their old annuities and into new ones when the current surrender period expires. We've also seen cases where brokers convince customers to switch even before the surrender period expires.

The brokers do this even when the new product may not be a better investment and will only tie up the investor's money for a longer period of time with a new surrender period. This can be especially devastating for seniors.

Earlier this year, as part of FINRA's ongoing efforts to curb abuses in the sale of variable annuities, we fined Banc One of Chicago $225,000 for making unsuitable sales of deferred variable annuities to 23 customers. Twenty-one of the 23 customers were over 70 years old.

In addition to the fine, FINRA also required Banc One to allow each of the 23 customers to sell their variable annuities without penalty.

Ordinarily, these variable annuities would have been subject to a six-year "surrender period." This would have required customers to pay surrender charges as high as 7 percent if they were sold in the first two years.

FINRA found that, in each of the 23 transactions, Banc One representatives recommended that the customers exchange their fixed annuities, which were then paying a minimum of three percent, for variable annuities.

But then the customers were convinced to place 100 percent of their assets into the fixed rate feature of the variable annuity, which paid a maximum of three percent.

All but one of the fixed annuities originally owned by the customers were beyond the surrender period—that is, the customers were not subject to any financial penalties if they withdrew any of their funds from the fixed annuity.

But when they then purchased these variable annuities they were subject to a new six-year surrender period requiring the customers to pay a penalty if they withdrew more than the sum of their earnings and 10 percent of their principal.

Needless to say, FINRA found that each of these 23 recommendations was unsuitable, given the customer's age, investment objective, financial situation and income needs.

The settlement cites one example of an 80-year old customer who exchanged a fixed annuity earning three percent for a variable annuity, in which he invested the entire $80,000 balance in the fixed income feature, which also paid 3 percent interest.

This new variable annuity was subject to a six-year surrender period. Within the first year of owning the variable annuity, the customer withdrew $9,000. Sixteen months after buying the variable annuity, the customer liquidated it and incurred a $4,628 surrender fee.

It quickly became clear to us that Banc One had inadequate systems and procedures governing annuity sales.

FINRA found that Banc One failed to adequately supervise these transactions and that the firm's supervisory system and procedures failed to require firm supervisors to obtain or consider certain critical information.

When firms are recommending annuities to any customer, they must act in the customers' best interests, taking into account all relevant factors - including the customers' ages and liquidity needs, surrender charges, product expenses and investment features. If my own experience is any guide, they may need a lot more explanation.

Firms and brokers have an obligation to treat the public fairly and help them understand their investments. And complex products like variable annuities need more explanation than other investments.

I've looked at the Riders in the cases we've investigated. Frankly, I found it confusing to deal with all the possible bells and whistles, and it was particularly difficult to find clear written disclosure of the costs and benefits of each rider. What's more, when we asked brokers to explain them, some could not. My experience taught me that this is far from a simple, straightforward product. Riders may benefit some customers who need the assurance of guaranteeing a certain amount of money. Some of these new features—such as a lifetime income benefit—may be appropriate for some investors. But they are complicated features that must be fully explained—with both the pros and cons fully disclosed. That's why training and supervision is so important.

Earlier this year, FINRA took action to revise the rules governing communications with the public concerning variable annuities.

The proposal would shorten and simplify some of the guidelines and would make clear that discussions of riders must be fair and balanced. A rider's costs and limitations must be clearly disclosed to customers. It would also set clearer standards for the use of hypothetical illustrations and investment analysis tools.

We believe that by revising these guidelines we will be better able to address the features and types of variable insurance products offered in today's marketplace.

We've done it before. From the very beginning, we've worked with the industry on Rule 2821, which governs variable annuity sales practices. We made extensive changes that reflected our careful consideration of the issues that the industry raised concerning the original proposal.

For example, we created a broad exemption for transactions in connection with qualified employment plans. We also eliminated an earlier proposal for a written, product-specific disclosure about the variable annuity being offered. And we eliminated a proposed requirement that firms determine that their customers "need" the variable annuity in comparison to other products.

In a similar vein, we also modified the requirements for principal review to give firms more flexibility in approving customer transactions. Nevertheless, we continue to believe this aspect of the rule proposal is vitally important. The requirement for principal review of variable transactions not only protects investors, but better ensures that problems will be caught early and that transactions will not have to be unwound.

These changes were made only after thorough consideration of whether the modifications would advance our goal of protecting investors. In each case, we listened carefully to firms' comments and crafted changes that addressed legitimate concerns. Our goal with any rulemaking process is to advance investor protection and market integrity, without putting unnecessary complexity into the process.

In fact, while the Recommendation Requirements and Training provisions of Rule 2821 became effective in May, we've delayed the effective date of the Principal Review and Supervisory procedures. There were three sources of contention that led us to believe that these sections needed to be further modified.

First, the rule as currently written requires principal review and approval "prior to transmitting a customer's application for a deferred variable annuity to the issuing insurance company for processing, but no later than seven business days after the customer signs the application."

A number of firms asserted that seven business days beginning from the time when the customer signs the application may not allow for a thorough principal review in all cases.

These firms provided examples of situations where a principal might not be able to complete the required review within the allotted time, such as when a customer inadvertently omits information from the application or when a customer signs the application but does not mail it for several days after signature.

FINRA is proposing to change the triggering event that begins the principal review to no later than seven business days after an office of supervisory jurisdiction of the member receives a complete and correct application package.

Second, Rule 2821 requires that a principal treat all transactions as recommended for purposes of the principal review requirement. Some firms have questioned whether this makes sense for firms that do not make any recommendations to customers and do not employ principals to perform suitability reviews. Our proposed changes would limit Rule 2821 to recommended transactions.

And finally, some firms asked FINRA to reconsider its position prohibiting the deposit of customers' funds in an insurance account prior to completion of a principal review.

According to these firms, insurance companies use an identifier to track money held in the suspense account, and if a contract is not issued, the funds are promptly returned to the customer.

In response to these concerns, we are proposing to clarify when a customer check can be forwarded to an insurance company prior to the approval of the deferred variable annuity. Stay tuned for more of these important modifications.

Closing

Before I close, let me return to that question posed to me by the reporter in New York two weeks ago. "Given all the problems with variable annuities, why don't regulators just eliminate them from the marketplace?"

My response to that reporter was pretty simple.

I said that, yes, there have been problems in the past caused by the high commissions and questionable sales tactics surrounding variable annuities-there's no question about that.

But I added that these products can be appropriate for some investors; they have a role in the marketplace, particularly as so many investors approach retirement without a traditional pension. But proper sales practices must be honored.

Why do I believe that? Because I believe investors deserve choices. They deserve an array of investments to choose from.

But they also deserve investments marketed and sold in an open and transparent manner; where commissions and fees are not the driving force behind brokers pushing investors into products that are wrong for them and will only take them further away from their financial goals.

That was my answer to that reporter—and my message to you this morning is just as simple.

But I would add one thing: I also believe FINRA and the industry can and will work cooperatively to address the issues surrounding variable annuities. After all, that's the strength of self-regulation-and why we created FINRA.

So as I leave you today, I want you to know that FINRA is here to listen to industry concerns when we write any new rules on variable annuities.

And I want you to know that FINRA will offer you sincere guidance on how best to comply with those rules.

But I also want you to realize one thing: that FINRA has made regulating variable annuities a top priority, and we are ready to enforce those rules to protect the integrity of the marketplace for firms and investors alike.

Thank you very much for inviting me to speak—it's been a pleasure.