SEC Publishes Controversial Proposal By NASD to Target Annuities Sales Practices

By Rachel McTague

The Securities and Exchange Commission July 21 published for comment a controversial NASD proposal to adopt a new rule imposing specific sales practice standards and supervisory requirements on members for transactions in deferred variable annuities (Release No. 34-52046A, 7/19/05; 70 Fed. Reg. 42126, 7/21/05).

In particular, proposed NASD Rule 2821--which has been strongly opposed by the variable annuity industry--would create recommendation requirements, including a suitability obligation, principal review and approval requirements, and supervisory and training requirements tailored specifically to transactions in deferred variable annuities.

Hybrid Investments

Deferred variable annuities are hybrid investments containing both securities and insurance features. The annuitant generally controls how the principal is invested, and the future payment stream from the annuity depends on the value of the portfolio over time. In its statement of purpose filed with the SEC, NASD said it has faced persistent sales practice problems in the deferred variable annuity area. NASD recounted, "In some instances, associated persons sold deferred variable annuities to elderly customers for whom such long-term, illiquid products were not suitable. In others, associated persons sold deferred variable annuities without explaining ... the characteristics of the products. On a number of occasions, associated persons recommended that customers exchange one deferred variable annuity for another without ensuring that such exchanges were beneficial for their customers or properly disclosing costs."

However, NASD's notices to members, investor alerts, regulatory alerts, strengthening of its examination program, and significant enforcement actions to combat such practices were unsuccessful, the self-regulatory organization reported. A joint SEC-NASD report in June 2004 and an ongoing special examination of various members discovered similar problems.

Further, NASD said it has received investor complaints indicating that the customers did not understand the unique features of the product. These complaints, NASD said, raised suitability concerns based on the customers' investment objectives and liquidity needs.

Negative Comments

NASD noted that when it sought comment in a Notice-to-Members in June 2004, it received 1,129 comments, and the "overwhelming majority of commenters opposed the proposal." Only 14 commenters fully supported the proposal and an additional 20 commenters offered partial or qualified support for the proposal, NASD said. The Securities Industry Association, the American Council of Life Insurers, the National Association of Insurance and Financial Advisors, and the Association for Advanced Life Underwriting wrote to NASD in August last year forcefully objecting to the rule proposal (36 SRLR 1490, 8/16/04 ).

ACLI Vice President and Chief Counsel Carl Wilkerson told BNA July 28 that he sees "positive aspects and less positive aspects" in the final proposal. "On the positive side," he said, "NASD has jettisoned the risk disclosure document at the point of sale. Other aspects of the rule are of greater concern." Wilkerson said ACLI remains very concerned about the "free-standing single product suitability rule" that the proposal would impose.

The ACLI lawyer also said NASD has not quantified the economic burden of the proposed rule to limited purpose broker-dealers. Finally, he said, "NASD hasn't empirically demonstrated the scope of the problem or that the rule would solve the alleged problem." Wilkerson said that on July 27, he asked the SEC for an extension of the 21-day comment period.

Need for Proposal

According to NASD, most commenters "questioned the need for the proposal described in the Notice, stating that the proposal is duplicative of existing rules and that NASD should simply enforce those existing rules. NASD disagrees."

NASD urged that the proposed rule does not merely aggregate existing requirements. For example, it explicitly requires that an associated person have reasonable grounds for believing that the customer has been informed of the material features of the deferred variable annuity. It also describes the type of information that an associated person must consider in determining the suitability of an investment in a deferred variable annuity.

Rest of Package May Come Later

While NASD proposed written point-of-sale disclosure requirements in its Notice, those requirements were not included in the current proposal. NASD said it "will continue to explore this issue and will separately consider whether to propose such requirements in the future." NASD also modified the originally proposed principal review requirement in the final proposal. Under the Notice, a principal would have had to review and approve the transaction no later than one business day following the date when the customer signed the application. As proposed here, the rule would require principal review, and, if appropriate, approval before the member or person associated with the member transmits the customer's application for a deferred variable annuity contract to the issuing insurance company.

In response to commenters, NASD said it created an exemption for certain transactions involving tax-qualified, employer-sponsored retirement or benefit plans.

Comments are due by Aug. 11 and should refer to File No. NASD-2004-183.