Regulators Send Message To Sellers Of Securities: Beware

Securities regulators have continued to target practices used by broker-dealers to sell variable annuities and have started targeting certain practices used to sell mutual funds.

On May 27, 2003, for example, the National Association of Securities Dealers issued an Investor Alert for the investing public.

Entitled “Variable Annuities: Beyond the Hard Sell,” the Investor Alert carries a clear message: Beware of aggressive sales tactics by sellers.

For sellers, the implicit message is that they, too, should beware–in this case, beware of regulatory scrutiny of their sales practices.

The Alert begins with a warning to seniors that some sellers may use “scare tactics.” It continues its cautionary tale and provides factors an investor should consider before purchasing a variable annuity, including:

Liquidity and Early Withdrawal. The Alert advises that deferred variable annuities are long-term investments, and that early withdrawal may result in sales charges and tax penalties.

Fees and Expenses. The Alert discusses the different fees and expenses imposed under a variable annuity, including the surrender charge. It notes that there are additional charges for special features and warns investors not to pay for them if “you dont need or want these features.” The Alert warns that variable annuities offering bonus credits typically impose higher mortality and expense charges and lengthy surrender charge periods.

Taxes. The Alert advises that investors should consider annuity products only after they make their maximum contributions to 401(k)s and other qualified plans. It notes that earnings withdrawn from annuities are taxed at ordinary income rates, rather than the lower capital gains rates, and that there is no “stepped up” basis on annuity proceeds upon the death of the owner. It also warns that investing in a variable annuity within a tax deferred account “may not be a good idea.”

Guarantees. The Alert warns that guarantees backed by an insurance company, such as the death benefit or annuity payout, “are only as good as the insurance company that gives them,” and suggests that investors research the insurers credit rating before investing.

Finally, the Alert reminds investors that if they already have purchased a variable annuity and are “having second thoughts,” the annuity may have a free-look period that would allow the investor to cancel the policy.

At the same time that it issued the Alert, the NASD announced it had censured and fined an insurance-related broker-dealer for inadequate procedures governing its sale of variable products and its handling of customer complaints. The NASD also announced it had filed three separate complaints against individual brokers for unsuitable sales of deferred variable annuities.

Insurance sales are not the only focal point of recent regulatory moves. Regulators also have been finding fault with some sales practices in the mutual fund arena.

One example is a March 2003 report issued by the Securities and Exchange Commission, the NASD and the New York Stock Exchange. This report concluded that broker-dealers failed, in many instances, to provide breakpoint discounts in front-end sales loads on the sale of Class “A” mutual fund shares.

In late July 2003, a “breakpoint task force,” including the NASD and representatives from the mutual fund and broker-dealer industries, published a follow-up report. This report recommends reforms that would improve the implementation of breakpoint discounts in front-end loads.

The SEC and NASD have made it clear that they will continue their examinations in this area and may pursue disciplinary actions.

In addition, the SEC and NASD have announced investigations and have instituted proceedings against broker-dealers for selling Class “B” shares to investors when other classes may have been more appropriate, such as where breakpoint discounts would have been available on Class A shares.

In one action settled in July, the SEC fined a major broker-dealer $300,000 and ordered disgorgement of $82,000 for the improper sale of Class B shares. The SEC is also pursuing charges against the registered representative who made the sales.

At the same time, the NASD issued an Alert warning investors about the expenses involved in purchasing Class B shares, explaining how to determine which share class might be appropriate, and highlighting when investors should look for breakpoint discounts.

In sum, securities regulators are pressing forward on suitability concerns regarding variable annuities and mutual funds. Recent concerns about mutual fund sales have focused on the cost of purchasing the shares. Concerns about variable annuity sales have focused on cost, liquidity, tax treatment and other aspects of the contracts.

Jeffrey S. Puretz is a partner and Michael D. Pappas is an associate with the law firm of Dechert LLP. Both reside in the Washington, D.C., office and can be contacted at jeffrey.puretz@dechert.com. and michael.pappas@dechert.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, August 11, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.