Interpretive Letter to Eric A. Arnold, Esq., Sutherland Asbill & Brennan LLP
October 12, 2000
Eric A. Arnold, Esq.
Sutherland Asbill & Brennan LLP
1275 Pennsylvania Avenue, N.W.
Washington, D.C. 20004-2415
Re: Definition of "Affiliated Member" under the Non-Cash Compensation Rule
Dear Mr. Arnold:
I am responding to your letter of July 19, 2000 to Ms. Stephanie Dumont requesting an interpretation of the scope of the term "affiliated member" under NASD Rule 2820. Specifically, you ask whether the contemplated relationship between Equitrust Marketing Services, LLC ("Equitrust"), a member of the National Association of Securities Dealers, Inc. ("NASD"), and a potential insurance company owner makes Equitrust an "affiliated member" of that insurance company for purposes of Rule 2820(g)(4)(D).1
Your letter indicates that Equitrust is a limited liability company that has a "Principal Member" that owns all the voting interests in Equitrust. Equitrust also has "Associate Members" that have no voting interests in the company. The Associate Members are licensed insurance companies that are required under limited liability company agreements with Equitrust to make initial capital contributions, respond to certain capital calls from Equitrust, and maintain $50,000 in their capital accounts at all times.
The Associate Members are engaged in the distribution and sale of variable life insurance, variable annuity and mutual fund products, which have been approved by Equitrust’s Board of Managers for Distribution. The Associate Members have agents who are licensed by the appropriate authorities to sell certain lines of insurance products. Agents of Associate Members that meet certain criteria set by Equitrust’s Board of Managers may become registered personnel ("Associated Agents") of Equitrust. In this regard, each Associate Member designates its home office location as an Office of Supervisory Jurisdiction ("OSJ") of Equitrust. The OSJ has a registered principal ("Designated Officer") who is responsible for the supervision of the Associated Agents. In most cases, the Associated Agents report to the same personnel for both their securities activities and their insurance activities.
Your letter indicates that the Associate Member’s line of business is allocated all the revenues that it produces, and is also allocated its share of expenses. Equitrust’s general overhead is allocated to the Associate Members equitably, and all other expenses (e.g., registered representative expenses, commissions payable by Equitrust to the Associated Agents, NASD assessments) will be allocated to the Associate Member. If an Associate Member incurs expenses directly (e.g., salaries, supplies, rent), it may submit such expenses to Equitrust for reimbursement, but such reimbursement shall be made only from the capital account of the Associate Member.
Proposed New Associate Member
Your letter indicates that Equitrust is negotiating to add another insurance company ("Proposed Associate Member") as an Associate Member. The Proposed Associate Member differs from current Associate Members in two regards: the Proposed Associate Member will itself be issuing variable contracts; and the Proposed Associate Member hopes to integrate those variable contract sales made by its Associated Agents into its own non-cash compensation arrangements for its agents.
Request For Interpretation
Your letter asks whether Equitrust would be considered an "affiliated member" of the Proposed Associate Member for purposes of Rule 2820(g)(4)(D). In analyzing this question, you indicate that Equitrust should be considered an affiliated member of the Proposed Associate Member because certain of the policy concerns underlying Rule 2820(g)(4)(D) (potential loss of supervisory control over sales practices and potential creation of significant point-of-sale incentives that may compromise suitability determinations) are not implicated by this arrangement. Your letter also indicates that Equitrust meets the definition of affiliated member contained in Rule 2820(b) because the Proposed Associate Member controls Equitrust. Your letter suggests that the Proposed Associate Member controls Equitrust through its approximate 5% contribution to Equitrust’s total capitalization. Your letter also indicates that the Proposed Associate Member controls the operations of Equitrust2 by virtue of its contractual obligations to oversee the operations of its Associated Agents and the OSJ, and its contractual duty to control its line of business.
Rule 2820(g)(4) provides that no member or person associated with a member shall directly or indirectly accept or make payments or offers of payments of any non-cash compensation in connection with the sale and distribution of variable contracts. Rule 2820(g)(4)(D) provides that notwithstanding this general prohibition, a non-cash compensation arrangement is permitted between a non-member company and its sales personnel who are associated persons of an affiliated member provided certain conditions are met. As previously noted, Rule 2820(b)(3)(A) defines "affiliated member" as "a member which, directly or indirectly, controls, is controlled by, or is under common control with a non-member company."
As stated in NASD Notice to Members ("NtM") 98-75 (September 1998), the non-cash compensation rules permit a non-member whose sales personnel are associated persons of an affiliated member to participate in a non-cash compensation arrangement, which is partly in recognition of non-member insurance companies that may hold non-cash sales incentive programs for their sales personnel who are also associated persons of the non-member’s affiliated broker/dealer and are licensed to sell both variable contract securities and non-securities insurance products. The NtM further states "[a]s a practical matter, an insurance company . . . affiliated with a broker/dealer is in a position to contribute to and affect the structure of its affiliated broker/dealer’s in-house incentive compensation program." In other words, when an insurance company is affiliated with a broker/dealer, it often has the ability through its relationship of ownership or control to change the broker/dealer’s incentive compensation program to accommodate the program in place at the insurance company.
Based on the representations in your letter, the staff does not believe that the Proposed Associate Member exercises control over Equitrust such that it could affect Equitrust’s incentive compensation program. The Proposed Associate Member has no voting interest in Equitrust and it contributes 5% to Equitrust’s total capitalization, an amount insufficient to create a presumption of control under either NASD Rule 2720 or Form BD, which are referenced by analogy in your letter. As your letter noted, Rule 2720 presumes control when a partnership interest permits a 10% or greater distribution right; Form BD presumes control when any person contributes 25% or more in capital. Moreover, the relationship between the Proposed Associate Member and Equitrust appears to involve primarily the activities of Associated Agents and does not indicate an ability of the Proposed Associate Member to affect the non-cash compensation program of Equitrust.
NASD Regulation, Inc. staff generally refers to those "control" persons listed on a member’s Form BD in determining whether a party is an affiliate of the member for purposes of the non-cash compensation rules. The Form BD defines control as "the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise." While certain employees of the Proposed Associate Member are involved in the operation of one of Equitrust’s lines of business, we do not believe that such activities result in the Proposed Associate Member having the power to direct the management or policies of Equitrust.
Your letter also makes various policy arguments as to why Equitrust should be treated as an affiliated member of the Proposed Associate Member under Rule 2820(g)(4)(D). It is the staff’s position, however, that the facts described in your letter do not evidence the control relationship between Equitrust and the Proposed Associate Member that is required by the plain language of Rule 2820; therefore, the staff is unable to consider policy reasons as to why Equitrust should be treated as an affiliated member of the Proposed Associate Member for purposes of the rule.
I hope that this letter is responsive to your request. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation, Inc. This letter responds only to the issues you have raised based on the facts as you have described them in your letter, and does not address any other rule or interpretation of the NASD, or all the possible regulatory and legal issues involved.
Sarah J. Williams
1 We note that your letter references Rule 2820(h)(4)(D). Effective April 1, 2000, the provisions of Rule 2820 were renumbered, and Rule 2820(h)(4)(D) was redesignated as Rule 2820(g)(4)(D). See NASD Notice to Members 99-103 (December 1999).
2 Rule 2820(b)(3)(A) defines "affiliated member" as "a member which, directly or indirectly, controls, is controlled by, or is under common control with a non-member company."