Remarks at the NASD Spring Securities Conference

Mary L. Schapiro

Vice Chairman, NASD President, Regulatory Policy and Oversight

Baltimore, MD

May 12, 2004

Good afternoon and welcome to you all.

In Washington, the land of over-sized egos, there's an expression that speakers have been heard to use, half in jest, when they're appearing at the end of the day:

"Everything that needs to be said has been said. But not everyone has said it."

Being in that position now, I shall try to rise to the challenge of not repeating what has already been said - and to the larger challenge of keeping your attention at 4:30 in the afternoon, when some of you are starting to wonder whether, an hour from now, you're going to have a martini or a gin and tonic.

So, mindful of the need to be brief and focused, I would like to talk about two products that are among those most frequently sold to investors and where we have heightened concern about sales practices. My concerns stem from what we discover in our exam program and enforcement sweeps, what we read in the sales and promotional materials that firms utilize, and from the complaints and concerns we hear directly from investors, whether in letters or voiced in person at one of the many Investor Forums we hold around the country.

Sales practices dictate how most people will end up feeling about your firm and our industry. When a broker takes the time to learn about his customers' needs and desires, makes recommendations without regard to a higher payout or the firm's revenue sharing receipts, directed brokerage or other payments, and those recommendations are designed (not guaranteed, but designed) to help clients achieve their goals, are accompanied by clear explanations of the risks as well as the potential rewards of the investment, --- then that broker leaves an impression of professionalism and service that should be the hallmark of the financial services industry.

Every encounter with an investor or potential investor - in person, on the phone, through sales material and advertising - all contribute to the impression and ultimately the quantum of trust investors have in the securities industry. Investor trust and confidence can't be decreed from above or bestowed upon the industry by regulators. They are precious and fleeting and must be earned and built every single day. This is critical for the success of each firm, the entire industry and our economic well being as a nation.

So with that plea and introduction, I would like to talk about sales practices in the context of several products.

Variable Annuities

The first is deferred variable annuities. The way variable annuities are sometimes marketed to investors has long been a concern of ours. An advertisement we came across recently suggests this concern is not ill-founded: produced by a Texas firm that specializes in reverse mortgages, the ad shows a photo of an elderly couple standing on their front porch. The text reads:

"Sell Annuities to Seniors Who Don't Have Money! Most Have Equity in their Homes. Help Your Agents Tap into It!" At the bottom, next to the 800 number, it says, "Ask for Ralph."

It's hard to know whether to laugh or cry when you see something like this. And I wish I could say that predatory tactics such as these were rare. But as variable annuities have increased in popularity, particularly among elderly investors, abusive sales practices have increasingly reared their ugly heads.

Now, it would be very troubling to me and I know to all of you as well, if regulators relied upon anecdotes such as this one, to build a case for a new set of regulatory requirements. In the case of variable annuities, we have a solid track record of looking at the products with their ever-changing array of features, and examining closely the sales practices associated with them.

We, and our industry committees were sufficiently concerned about it back in 1999, that we published best practice guidelines covering disclosure, suitability, account opening and sales practice issues for variables. But since then, it has become clear that while some firms embraced the best practice guidelines, many did not, and our exams have raised more and more red flags.

Just in the last few months, we have brought three important enforcement actions in this area.

In January, we fined Prudential Securities $2 million and ordered it to pay customers $9.5 million for annuity sales and switches that violated New York State insurance regulations. New York law sets forth very specific contact requirements and information disclosure to ensure that investors will not be pressured into making spur of the moment decisions regarding annuity switches.

The regulation requires documentation of two separate interactions with a customer, documentation of specific information about the old annuity contract, and disclosure of comparison information before a replacement sale can be completed. Intentionally short-cutting those required steps increased the opportunities for misrepresentation and reduced the ability of investors to make informed comparisons between their current annuity and the proposed replacement, gutting the important investor protection aspects of the New York law.

In January, we permanently barred a Louisiana broker from the industry and ordered him to pay more than $1.5 million in restitution for making unsuitable annuity sales to older, conservative investors.

Also in January, we also filed a case against Waddell & Reed and two of its senior executives, charging the firm with recommending 6,700 annuity exchanges to its customers - generating $37 million in new commissions and costing the customers $10 million in surrender fees - without determining whether the transactions were suitable. You all know better than I - because you live with this important obligation - that the suitability analysis is the foundation of good and compliant sales practices. We are following closely any situation where we learn of large scale switching and we will look specifically to see that adequate suitability analyses were done in all cases.

These are just the three most recent of the more than 80 disciplinary actions NASD has taken in response to troublesome variable annuity sales practices in the last two years - practices such as persuading investors to switch with no reason, causing them to incur unnecessary surrender fees and commissions; recommending that investors buy deferred annuities within their 401(k) plans without disclosing that there is no tax advantage beyond those that the 401(k) provides; selling an annuity with a death benefit without telling the investor that the death benefit's value is subject to reappraisal some years down the road, based on prevailing market conditions.

These are among the experiences that motivated us to codify the best practice guidelines and propose them as rules for comment. Under the new proposal, there are heightened disclosure requirements for delivery of not only a prospectus, but also a plain English risk disclosure document, highlighting the key features of the annuity including liquidity issues, such as surrender fees and IRS penalties, administrative, mortality and advisory or other fees associated with special features of the annuity, applicable federal, state and local premium taxes, market risk and whether a free-look period applies.

Before a broker can effect a transaction, it would have to be approved by a registered principal after considering specific factors such as whether the investor's age or liquidity needs make a long-term investment inappropriate. The principal must also approve in writing the suitability analysis for the annuity sale or exchange. The suitability analysis includes a determination that the variable annuity as a whole and its underlying subaccounts are suitable.

Many firms have told us that these ideas represent what firms really should be doing already, but I know we will get lots of comment on this proposal and we look forward to working through the issues to ensure that the sales practices in this part of the market serve investors well.


I also want to talk about sales practices in relation to one other investment category - 529 college-savings plans. Granted, these can be confusing to both brokers and investors. There are lots of complexities to consider when matching a client with a 529 and it does not help either brokers or investors that there is no standardized disclosure.

I own 529 plans for my two daughters - I think they were and are a great idea and if they encourage people broadly to really save for college, just imagine the societal benefits. So, potentially a great product, excellent tax benefits, and filling a pressing need for many American families. In fact, because the issuers are State Governments, they even have a little marketing edge…

But the suitability and other sales practice obligations that brokers have when selling a 529 plan are not in any way diminished by the fact that this can be a very good asset class for many investors.

Late last summer, we began to look six firms, (since expanded to 15) which we selected based on number of customer complaints and sales volume of particular plans to see how their plans were being sold and to whom. We were surprised, to say the least, to discover that more than 90 percent of the sales by some of those firms were to out-of-state residents given the fact that about half of the states give a state tax deduction to their citizens for contributions to the home state's 529 plan. And in some states, it is a very significant deduction.

Let me say clearly that it is not necessarily a violation of any rule to sell an investor an out of state plan - it is possible that the in-state plan's fees are so high, or the performance so poor, or that it offers no state tax deduction, so that another plan might be a perfectly suitable, even preferable recommendation. But the analysis has to be done.

And of course, we want to understand why are there so many sales of out-of-state plans? Did investors understand that they were forgoing a significant tax benefit? What kind of disclosure did they get? How were the brokers in those firms compensated?

While we have not yet seen the kinds of egregious abuses in 529 sales that we have seen with mutual fund and variable annuity sales, we are concerned enough to be looking carefully. Since 529s are state-sponsored products, they are exempt from most federal securities regulation. Congress placed them under the purview of the Municipal Securities Rulemaking Board, which has rules governing 529s, but no authority to enforce them. So enforcement falls to us.

That being the case, my view is that broker-dealers need to be better informed and better equipped to explain to customers the complexities of these plans. Let me point you to two great tools on the NASD Web site. Our booklet, Smart Saving for College details all of the features of 529 college savings plans, as well as other vehicles for college savings including Coverdell Education Saving Accounts, prepaid tuition plans, custodial accounts, and even U.S. Savings Bonds.

The booklet, which you should feel free to distribute within your firms and to clients, answers most every question imaginable about 529s. The other is the 529 College Savings Plan Expense Analyzer. Here, you can plug in the numbers that you find in the Plan Disclosure Document and can easily compare the costs of different plans.


I could carry the sales practice theme further and talk about mutual funds, bond funds, non-conventional products, fee based accounts, hedge funds and funds of funds. These have all been the recent subjects of various Notices to Members and they all have a similar theme, which will allow me to conclude where I began. The burden on a firm in recommending any of these products is to ensure that your sales practices are the best they can be and that suitability trumps all other considerations.

So now, with the markets newly showing signs of life, and with Google leading what may be a resurgence of IPOs, we have the opportunity to learn from our experiences. Having recently lived through the bursting of a market bubble, let's all take stock of what we did right and what we did wrong so that we'll be prepared in the event another bubble is starting to inflate.

Now more than at any time in recent history, the securities industry, and we who regulate it, need to devote ourselves utterly to the task of restoring the faith of investors in the integrity of the capital markets. That faith has been badlydi diminished, and the process of rebuilding it will be long and difficult. I suggest that a laser-like focus on sales practices would be a very good starting point.

Thank you very much for being here and I'll now open the floor to your questions.