Published: 03/01/2007
The Investment that Securities Regulators Love to Hate
Proposed NASD Rule 2821, "Members' Responsibilities Regarding Deferred Variable Annuities," is a direct result of the NASD's conclusion that its enforcement efforts have been unsuccessful in correcting perceived sales practice, supervision, and training problems associated with the sale of variable annuities. The comment period for proposed Rule 2821 closed on July 19, 2006. If approved by the SEC, the proposed Rule's effective date will be 180 days following publication of the Notice to Members announcing Commission approval. As of this writing, the Rule will go into effect no earlier than the spring of 2007.
Overview of proposed requirements of Rule 2821
The proposed Rule will impose four main requirements. First, it creates a specific suitability obligation. The member and associated person must have a reasonable basis to believe that: (1) the customer has been informed of all material features of the product, including surrender periods and charges, fees and expenses, and features of riders; (2) the customer would benefit from the unique features of the product; and (3) the product, as a whole, taking into account the underlying subaccounts, riders, and enhancements, is suitable for the client in light of the specific financial risk and experience information disclosed by the client. The Rule will require that these determinations be reflected in a document signed by the associated person recommending the purchase.
Second, the Rule will create various principal review and approval obligations, the primary one being the review and approval of the transaction by a registered principal no later than two business days following the date when the customer's application is transmitted to the issuing insurance company. As with the suitability obligation, the principal review and approval will have to be reflected in a document signed by the registered principal.
Third, the Rule will specifically require member firms to establish and maintain written supervisory procedures reasonably designed to achieve compliance with the provisions of the Rule.
Fourth, the Rule will require members to develop and document specific training policies and programs reasonably designed to ensure that associated persons who effect and the registered principals who review variable annuity transactions comply with the requirements of the Rule and understand the material features of variable annuities generally.
Discussion of the Rule's Implementation
The discussion accompanying the Rule filing sheds some light on the NASD's thinking on implementation of the Rule. As to supervision, the Rule does not preclude firms from using automated supervisory systems or a mix of automated and manual systems, provided, however, that the criteria for the automated system are reviewed and approved in advance by a principal and the system is audited and updated to ensure continuing compliance with the Rule.
As to the suitability requirements, the NASD declined to apply any bright-line tests for investment objective, age, net worth, or liquidity. Nevertheless, the discussion makes it quite clear that only in the "rare case" would a variable annuity be appropriate for someone without a long-term investment objective, and firms must carefully scrutinize transactions involving customers without long-term investment objectives and should carefully document any analysis in favor of that recommendation.
Finally, the proposed Rule is interesting for what it does not do. The proposed Rule applies only to the initial purchase or exchange of a variable annuity and the initial subaccount allocation. It does not apply to subsequent reallocations of subaccounts or to additional premiums paid into the annuity. In those circumstances, other NASD rules would continue to apply, including Rule 2310, the suitability rule.
Recordkeeping is Critical
The proposed Rule underscores the importance of good recordkeeping. As with any area of supervision, the best set of procedures in the world is essentially useless in the absence of clear contemporaneous records demonstrating that the procedures were implemented. It is essential that member firms establish efficient systems of reporting at the crucial steps of the process and perhaps use this opportunity to review and improve procedures and systems in other product areas.
William D. Nelson provides general representation of securities broker-dealers and state and federal registered investment advisors. He has extensive litigation, arbitration, and mediation experience in securities customer, industry, and employment disputes. Bill represents broker-dealers and registered investment advisors in regulatory and administrative proceedings before the Securities and Exchange Commission, National Association of Securities Dealers, New York Stock Exchange, and state regulatory agencies. Bill can be reached at 303-628-9539 or by email at wnelson@rothgerber.com.