Remarks at the 27th Annual SIA Sales and Marketing Conference

Elisse B. Walter

Senior Executive Vice President

Waldorf Astoria Hotel, New York, NY
September 28, 2004

Current NASD Regulatory Issues on Sales and Marketing


Thank you so much for inviting me to speak with you. I've been a regulator for - please don't gasp - 27 years and, if I've learned anything, it is that good communication between the industry and its regulators is vital to both sides of that equation. I'm pleased that we can play a small part in that effort today.

This morning I'd like to touch on a number of regulatory issues that we at NASD have been wrestling - issues that directly affect what you do in selling products to your customers. I'll try to give you an idea of what crosses the line into forbidden and unethical behavior. While none of us - just like our kids - like to be reminded of what we are not supposed to do, it is a pretty good way to stay out of trouble - or at least to understand what kind of trouble you are facing. But, we at NASD also try to work closely with the industry and give as much guidance as we can so you can spot issues BEFORE they become problems. I'll touch on those aspects of our work as well. Most important, I want to emphasize that our phone lines are always open. Feel free to call me or my colleagues if you'd like to talk about a question that concerns you, or even if you want to complain. This is a tough environment for your business, and a tough environment in which to be a regulator. Let's make it a little easier by working together where we can.

I was told that you have an interest in four main areas - mutual fund sales practices and fee disclosure, variable annuity sales practices, branch office supervision, and fee based accounts - I will comment on each.

Mutual Fund Sales Practices and Fee Disclosure.

First, mutual fund sales practices and fee disclosure.

Unless you been in the wilds of another continent, or another planet, and for a very long time, it will come as no shock to you that the world of mutual funds - those bedrock investments that offer diversification and professional management to middle America - has changed. Some say that mutual funds have moved from being America's most wanted investment to simply being "America's Most Wanted." Others say that mutual funds, long investing's conservative, staid grey lady from Boston, are now more like are Roxie in "Chicago," the play and the movie. A number of regulatory and legislative efforts have been launched to help move Roxie back to Boston, and I want to talk to you now about what we are working on in mutual fund sales practice and fee disclosure regulation.

I will touch lightly on four areas of mutual fund sales practices - B shares and NAV transfers, market timing and late trading, directed brokerage and sales contests - and then talk a little on recent disclosure developments.

First, B Shares and NAV transfers. Each has presented significant problems. As you know, B shares have no front end sales charge, but have a back-end load that normally declines the longer the investor holds his shares. B shares also typically have a higher annual 12b-1 fee than A shares until their back-end load declines to zero. We have issued several Notices to Members and member and investor alerts on B shares sales. These note that you should consider a fund's expense ratio and sales charges before recommending it. We have brought more than a few enforcement cases on this issue - nearly 3 dozen in the last four years - and likely you will see even more. We have found numerous instances of brokers steering investors into B shares when A shares clearly would be a better choice for the investors, but less profitable for the brokers. Remember that the customer gets the same product when she buys A shares and when she buys B shares. The only difference is how and when she pays.

Another issue is NAV - net asset value -- transfers. These are programs where customers who redeem fund shares on which they paid a front-end sales charge may use the proceeds, within set time periods, to purchase Class A shares of another fund family - without a front-end load. These programs are usually put in place for a limited time. Investors who qualify for NAV transfer programs have no reasonable basis to purchase any class of shares other than Class A. We have found that, similar to what happened with breakpoint discounts on Class A shares, investors have not always received these front end load breaks. There already has been one NASD disciplinary case on this issue, and, again, you are likely to see more. Here, as with breakpoints, there is a simple lesson to be learned by securities firms and mutual funds: You simply MUST deliver on your promises to customers.

A second mutual fund sales area is market timing and late trading. Late trading is a violation of SEC rules. Of course, there's nothing per se wrong with placing mutual fund orders after 4pm. Those orders, however, should get the NEXT day's price. Late last year, we asked a range of firms about this issue. We found a number that had mispriced orders through late trading, and others that were not always able to tell with clarity whether they had entered trades late. Both are problems: The latter shows poor internal controls and record keeping. We will pursue that issue as well as late trading itself. In recent months, we have brought a half dozen disciplinary cases related to late trading.

Market timing, on the other hand, is buying and selling securities on a short-term basis, where the investor profits from changes in market conditions. There is nothing illegal in this practice in and of itself. Many mutual funds, however, have policies that prohibit investors from market-timing, because purchase and sale orders cost the fund (and, thus, its shareholders) money, both in the administrative costs of processing orders, and in keeping larger cash positions, or having to sell portfolio securities, to respond to sell orders. Funds are serious about this, and often restrict the number of transactions, or impose penalties on frequent trades, and will even redeem all of a shareholder's shares and kick him out of the fund for violations.

Market timing occurs most frequently where there is an opportunity to arbitrage stale fund prices, and especially in international funds, where the underlying portfolio security prices may be 12 hours old as of 4 pm New York time, since the securities are traded on a foreign market that closed hours earlier. It is also a problem for funds that have thinly traded securities for which timely accurate price quotes may be limited, such as a small cap or bond fund.

In September of last year we addressed late trading and market timing in a Notice to Members. That Notice reminds members to have policies and procedures to detect and prevent late trading, as well as to prevent collusion with mutual funds to avoid the funds' anti-market timing policies contained in their prospectuses. Last February, we brought a disciplinary action against a firm, citing its inadequate supervisory systems, which improperly permitted trading beyond the limits set in the fund's prospectus. In June, we brought a second market timing case, the first ever related to variable annuities.

Most recently, we brought a third case in this area, in which a firm was prohibited from opening mutual fund accounts for new clients for 30 days, because it did not have an adequate supervisory system to prevent market timing abuses and late trading. As an aside, I'd like to note that we have found putting limitations on a firm's business to be a very effective form of remedy.

The third area of mutual fund sales practices is directed brokerage, or the practice of some mutual funds of directing portfolio securities transactions to broker dealers that sell shares of the fund. The practice raises a problem for investors, especially if a fund were "paying up," or trading securities at commission rates higher than the fund would pay if it were not indirectly paying for distribution through directing brokerage.

We reacted to this problem by adopting the "anti-reciprocal rule." This rule generally prohibits members from entering into directed brokerage arrangements with funds that reward sales and promotion of fund shares. Today, the rule does allow a firm to sell the shares of a fund that follows a disclosed policy of considering sales of its shares in deciding where to direct execution of its fund portfolio transactions. We have, however, proposed to eliminate even this option.

The fourth area of mutual funds sales practices involves sales contests and non-cash compensation. In the 1980's and early 1990's, mutual funds sponsored sales contests to increase fund sales and awarded prizes, such as vacations or cruises, to those selling them. Frequently, these prizes were "training meetings" at resorts, without much actual training going on.

We regulators worried that these contests led to unsuitable sales recommendations and damaged the industry's reputation. So, in 1998, we shifted how non-cash compensation could be awarded for mutual fund sales and drafted rules.

Those non-cash rules generally prohibit our securities firms and their staff from accepting any form of non-cash compensation, except for nominal gifts, or the occasional meal or sport or theatre ticket; training meetings; internal sales contests; and non member contributions to member internal sales contests.

Training meetings were allowed, but constrained with a number of conditions, including: that attendance does not require hitting a sales target, that the location must be appropriate, and that guest expenses are not covered. More recently, in the summer of 2000, we further clarified that the training in training meetings should occupy most of the workday, and entertainment expenses were not allowed.

Sales contests are closely related to non-cash compensation, and our 1998 rules also addressed them. Our rules state that any internal sales contest must not favor particular kinds of investments; they must be based on the total product sold by associated persons of mutual funds, variable annuities or variable life insurance products and the contest awards may not be based on the sales of particular funds or fund complexes; instead, all funds must be included and weighed equally.

In addition to mutual fund sales practices, I want to talk for a minute about mutual fund fee disclosure. While the SEC has authored most of the proposals in this area, NASD has also been active.

On our part, NASD in August of last year proposed requiring written disclosure to investors that fund fees can be found in the prospectus, the fund's selection of brokers can be found in the statement of additional information, any cash that a member gets from funds beyond those shown in the fee table, and any different rates of compensation reps get based on the funds they sell. We've also proposed requiring fund expense disclosure in all advertisements that promote fund performance.

The NASD's August 2003 proposal has been on hold because, in January of this year, the SEC proposed point of sale disclosure - written and oral - designed to inform the investor about fees, including the front end sales load and the part that would be paid to the broker, the 12b-1 fees to be paid out of the customers funds in the following year, the maximum amount of deferred sales load if the shares were sold in the first year after purchase, whether the broker gets revenue sharing or portfolio commissions from the fund, and whether it pays differential compensation for sales of B shares or proprietary funds. The SEC's proposal also prescribed confirmation statement disclosure that would be similar, but more extensive.

In May, NASD commented to the SEC on the Point of Sale aspect of this proposal. We suggested enhancements to the Commission's proposal that would:

  • Provide an investor with a snapshot of ALL costs, not just those that are distribution-related;
  • Make all disclosure with reference to a hypothetical investment amount, for easy comparability of funds; and
  • Require that a broker-dealer post all the disclosure documents, for funds it sells, on its website.

In February, the SEC adopted enhanced expense disclosure in shareholder reports, based on an investment of $1,000 using the funds actual expenses. It also proposed setting up procedures to detect directed brokerage, and amending Rule 12b-1 to prohibit directed brokerage and step out arrangements, that is, where the fund directs brokerage commissions to selling brokers who do not execute fund portfolio transactions to pay them for selling fund shares.

There has been a lot of discussion about, and work put into these issues, in the mutual fund industry, the securities industry and by regulators. Much still remains to be done. For example, NASD is currently facilitating the work of a Task Force composed of representatives of funds and brokers to provide the group's views to the SEC on issues ranging from soft dollars and portfolio transaction costs to 12b-1 fees and revenue sharing.

Variable Annuity Sales Practices

The second major area that I want to cover is variable annuity sales practices.

We have locked our focus onto variable annuities, and have been prodding, probing, and diagnosing their sales through examinations and enforcement cases for a while. We are now operating to cut a new rule on deferred variable annuities that the comment period has just closed on. But our case history should start five years ago.

In 1999, NASD's industry committees and NASD staff were sufficiently concerned about industry practices in selling variable annuities 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.

To bring you up to recent times, in May of last year, we issued a press release that detailed variable annuity abuses and announced an Investor Alert on them. In addition to announcing settlement of an action relating to failure to handle customer complaints properly, that release discussed three suitability complaints involving variable annuities that we thought were pretty egregious. For example, we cited the sale of a deferred variable annuity to a high school senior so that she would have a safe place to put her money, which she would need right after college for a house or a car. I know that these things are often sold to seniors, but not usually to high school seniors. We worry about sales to all seniors, including the high school kind: she didn't need a death benefit or tax deferral, and she certainly didn't need the tax penalty and surrender charges she would have incurred to buy that car with that annuity.

This year, we have brought a number of important enforcement actions in this area, three in January alone.

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 that ensure investors will not be pressured into making spur of the moment decisions on annuity switches.

Also 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.

And again in January, we filed a case, which is being litigated, 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.

In April we fined Long Island brokerage firm David Lerner Associates $100,000 for prohibited variable product sales contests.

In May we disciplined Nationwide Investment Services, Nationwide Securities and American Express and three brokers for variable annuity abuses.  Nationwide was fined for inadequate variable annuity sales procedures and systems, as well as using sales literature that didn't make required disclosures about the annuities.  American Express failed to keep records as required by SEC rules, which was discovered in an investigation of a former registered representative who converted client funds. The three brokers, who were with other firms, were barred or suspended for conversion, forgery, misrepresentation, and unsuitable sales.

In June we fined Davenport & Company for deceptive market timing in variable annuities.

And, these are just the most recent of the drumbeat of more than 80 disciplinary actions NASD has taken in response to troublesome variable annuity sales practices in the last two years. We brought these cases against 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 IRAs without disclosing that there is no tax advantage beyond those that the IRA provides, and 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 then prevailing market conditions.

But we haven't just been bringing cases. This June we issued a joint white paper with the SEC on the findings of our examinations of brokers who sold variable products. That report identifies both sound and weak practices in sales suitability, disclosure, supervision, training, and records management.

And, to build to a crescendo of sorts, we published our new rule proposal in a June Notice to Members. The proposal includes 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.

The proposal also requires that 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 must also include a determination that the variable annuity as a whole and its underlying subaccounts are suitable.

The comment period closed at the beginning of August. We have received many negative comments letters - not particularly surprising - but we also have been told that these ideas represent what firms really should be doing already. We are analyzing, ruminating on, and working through the issues to ensure that the sales practices in this part of the market serve investors better.

Branch Office Supervision

The third major area that I was asked to discuss today was branch office supervision. In this area, the important news is that we and the NYSE and NASAA have agreed on a uniform definition of "branch office". And we are now working to set up registration that will allow your firms to register their branch offices under the rules and regulations of state and self regulatory organizations through the CRD, just as firms and reps are now registered. The comment period on the Branch Office Registration Notice to Members, which proposes the new Form BR for Branch Office registration on CRD closed at the beginning of this month.

Our uniform branch office definition was submitted to the SEC in July of last year and the comment period expired in January of this year. It largely tracks the definition of "office" in the SEC's Books and Records Rules, and differs only in the treatment of some primary residences as offices. We support a primary residence exception that limits the activities you can do there; for example, no holding out of the house as a place to conduct business and no handling of funds or securities in the residence.

We believe this is an excellent example of making regulation less burdensome - but more effective - through standardization.

Fee-based Accounts

The final area that I was asked to cover today was the NASD's stance on fee-based accounts, sometimes called fees in lieu of commission.

These accounts typically charge a customer a fixed fee or percentage of assets under management in lieu of transaction-based commissions. NASD firms are increasingly offering them to their customers as an alternative to traditional commission based charges. You are probably thinking: "The 1995 Tully Report on Compensation Practices labeled fee based program a "best practice" because it more closely aligns the interests of the broker and the customer. Why is the NASD raising concerns now?"

Well, our Notice to Members of last November set out our thoughts on fee-based compensation, and we updated it with some Qs&As last month. In a nutshell, while fee based accounts can be a good thing, they are not always the right thing, or the best thing. We need you to look at each customer and determine what kind of fee works best for him or her. The Tully Report itself recognized that investors with low trading activity would probably be better off with a commission-based program that charges only when trades are made.

So how do you decide what is the best fee structure for your customers? NASD states that it is inconsistent with just and equitable principles of trade to put your customer in a fee structure that can reasonably be expected to result in a greater cost than alternative account that provides the same services and benefits to the customer. We believe that cost is an important factor, but not the only one. Other factors include the objectives of the customer, including the anticipated trading and non-price factors such as aligning their interests with those of the broker.

You need to determine that such an account is appropriate by making reasonable efforts to get information about the customer that will allow you to gauge the right kind of fee, based on the services provided, the cost, the alternatives, and the customer's preferences. You also need to tell the customer about the fee based structure and what it means. And you need to set up supervisory procedures to review those fees - we recommend annually - to make sure that they stay appropriate over time.

I wish that we could say that everything is fine in this area of the woods, but our examinations have found a number of problems, such as inadequate disclosure to customers about how the fees work, poor training of reps in how to tell what kind of fee is appropriate, lack of systems to prevent mutual funds and other products that can be bought outside a fee base account from being put into a fee based account to incur both a load and a fee, weak documentation of the choice of account type, no broker assigned to some fee based accounts, and lack of periodic review of whether a fee based account is still appropriate.

So we will continue to keep an eye on whether your firm is eyeing its fee based accounts closely - and frequently - enough.


In closing I don't need to remind you that regulation and customers have changed. Dubious practices, close calls, blurred interests have never been acceptable, but, in this age of CNBC, they become widely known, to everyone, and quickly. Industry practices are stared at by the press, the regulators, and most importantly, that average investor. If you can't stare back, without blinking or turning away when questioned, you are not prepared for business today. It is important that industry and regulators work together to assure that you, and we, can not only answer these questions, but provide an answer that we can be proud of.

Thank you very much for your attention, and I would be happy to take questions in the few minutes that I have left.