• FINRA Sets February 8, 2010 as the Deadline for Compliance with Rule 2821's Principal Review and Surveillance Requirements for Variable Annuity Sales
  • July 7, 2009 | Authors: John R. Snyder; Christine A. Bruenn; Donald S. Davidson
  • Law Firms: Bingham McCutchen LLP - Boston Office; Bingham McCutchen LLP - Portland Office ; Bingham McCutchen LLP - San Francisco Office
  • FINRA has announced February 8, 2010 as the effective date for Rule 2821’s principal review and surveillance requirements for variable annuity sales. The review requirements as initially proposed were controversial, prompting FINRA to defer their implementation and consider further the comments received. The most recent, and presumably final, version of the rule limits its application to recommended sales and changes the triggering event that starts the seven-day principal review clock to the receipt of “a complete and correct application package” by the office of supervisory jurisdiction.1

    This alert also summarizes an instructive recent FINRA enforcement action concerning variable annuity sales practices and supervision, and recent regulator comments on variable annuity guaranteed withdrawal features.

    FINRA Rule 2821

    Previous Bingham alerts summarized the tortuous history of Rule 2821, and its suitability and training requirements which took effect in May 2008.2 FINRA’s latest release, Regulatory Notice 09-32, focuses on two of the “four main areas of concern” addressed in Rule 2821:

    • Requirements governing broker recommendations, including suitability and disclosure;
    • Various principal review and approval obligations;
    • Requirements for member firms to establish and maintain supervisory procedures, and
    • Training requirements.

    The first and fourth components, governing suitability and training, took effect in May 2008 (2821(a), (b) and (e)).

    The New Amendments

    The amendments approved by the SEC in April to take effect in February 2010 will change the following the portions of the rule:

    • As of February 2010, the rule will apply only to “recommended purchases and exchanges of deferred variable annuities and recommended initial subaccount allocations.” Rule 2821(a)(1) (emphasis added). This change will bring Rule 2821 in line with FINRA’s general suitability rule, NASD Rule 2310. As FINRA points out, “because the vast majority of purchases and exchanges of deferred variable annuities are recommended by brokers, the rule will cover most transactions.”3 Note that, because the amendments are not effective until February 2010, for the next six months or so “old” Rule 2821 will continue to apply to all purchases and exchanges of variable annuities whether recommended or not.4
    • The selling broker will be required to transmit “the complete and correct application package” to the office of supervisory jurisdiction (“OSJ”) “promptly after receiving information necessary to prepare” that package. Rule 2821(b)(3).
    • If an agent recommends an exchange of a deferred variable annuity, the recommendation must be preceded by a determination that the exchange is suitable, “taking into consideration whether . . . the customer has had another deferred variable annuity exchange within the preceding 36 months.” Rule 2821(b)(1)(B)(iii). The rule as it currently stands requires only that the broker consider whether “the customer’s account” has had such an exchange in the preceding 36 months, i.e., the broker is required to look no further than the account for which the annuity is to be purchased. However, FINRA Regulatory Notice 07-53 did not read this provision so narrowly: “a registered representative must determine whether the customer has effected another exchange at the broker-dealer at which he or she is performing the review and must make reasonable efforts to ascertain whether the customer has effected an exchange at any other broker-dealer(s) within the preceding 36 months” (emphasis added). The language of the rule as amended is consistent with this guidance. Item .05 in the new Supplementary Material to the rule supplies some clarification with respect to the “reasonable efforts” that will satisfy this new requirement:  “Under this provision, a member or person associated with a member . . . must make reasonable efforts to ascertain whether the customer has had an exchange at any other broker-dealer within the preceding 36 months. An inquiry to the customer . . . would constitute a ‘reasonable effort’ in this context. Members shall document in writing both the nature of the inquiry and the response from the customer.”5

    New Provisions

    The portions of the rule that are to become effective in February 2010 concern principal review and approval of variable annuity sales and supervisory procedures (2821(c) and (d)).

    Principal Review and Approval. Reflecting FINRA’s concern that variable annuity sales practices have been plagued with problems, Rule 2821(c) imposes some unusual review and approval requirements. A registered principal must review and approve in writing all variable annuity applications before they are transmitted to the insurance company, and that review must be done within seven business days of the date the OSJ receives “a complete and correct application package.” Section (a)(2) of the rule expressly states that “documents may be created, stored, and transmitted in electronic or paper form, and signatures may be evidenced in electronic or other written form.” As with the registered representative’s review, the principal’s suitability determinations must be documented in a signed writing and must take into account all the same factors.6

    The seven-day principal review requirement of section (c) could pose logistical challenges. The rule contemplates a “thorough analytical review” of every recommended variable annuity transaction. SEC Release No. 34-56375 (Sept. 7, 2007), at 35. The reviewing principal likely will want to review all the documentation associated with the purchase, since he or she will be required to sign off on the suitability of the transaction. In some cases, the reviewing principal will not want to approve a transaction without speaking to the registered representative or obtaining additional information from the customer. In the case of an exchange, the registered principal will need to review the additional factors listed in the rule, including whether “the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual benefits), or be subject to increased fees or charges (such a mortality and expense fees, investment advisory fees, or charges for riders and similar product enhancements),” and whether the customer engaged in a previous exchange within 36 months, in which case the registered principal also may need to review details of the earlier exchange. See Rule 2821(b)(1)(B)(i) and (iii).

    In light of the time-consuming nature of the review contemplated by the rule and the heavy workload already imposed on branch office supervisors, firms may decide to assign the variable annuity review and approval responsibility to properly trained and licensed home office specialists. A centralized approval process has drawbacks too, since home office personnel may not have at hand as much information as a branch supervisor would have regarding the registered representative and the client. Another option would be to leave final approval responsibility with the branch supervisor but provide home office assistance from trained variable annuity specialists who could compare the contracts, review the paperwork, and alert the branch to any potential issues.

    Supervisory and Compliance Procedures. Member firms must maintain specific written supervisory procedures for complying with Rule 2821. Rule 2821(d). Firms also must implement special surveillance procedures designed to determine if their registered representatives are engaging in excessive switching and must adopt policies and procedures designed to implement “corrective measures” with respect to “inappropriate exchanges” and the conduct of representatives who engage in those transactions. FINRA Regulatory Notice 07-53 states that “a firm could perform this type of review on a periodic basis via exception reporting rather than as part of the principal review of each exchange transaction.”

    While it is a relatively straightforward matter to create exception reports capable of capturing both individual exchanges and levels of activity across a registered representative’s client accounts, it is far more difficult to design an automated system capable of making determinations about what constitutes an excessive rate of variable annuity exchanges. No blunt quantitative instrument can effectively perform what is essentially a qualitative judgment. The most these automated tools can do is identify transactions that may be problematic so that compliance professionals can undertake a qualitative analysis, which, of course, will have to be documented and preserved.

    Fifth Third Securities AWC

    A recent FINRA enforcement action provides a reminder of the sorts of variable annuity sales practice issues that attract regulatory scrutiny and reprobation, and therefore should be on the checklist for variable annuity sales review. An April 2009 Letter of Acceptance, Waiver and Consent (“AWC”) with Fifth Third Securities concerned sales by 42 brokers of 250 variable annuities which FINRA found to be unsuitable. Of those sales, 118 were exchanges of proprietary variable annuities recommended by a broker who had recently joined Fifth Third and, FINRA found, was “[f]aced with abandoning substantial customer assets at his prior firm.” FINRA asserts in the AWC that “[t]he clearest red flag was [the broker’s] ‘cookie cutter’ approach to the transactions — recommending and selling each of his customers the same VA with the same riders, which should have caused the firm to question if [the broker] adequately considered whether the transactions were appropriate for each customer.” According to FINRA’s findings, “the broker ignored substantial differences in his customers’ ages, incomes, investment objectives, and investment sophistication.” With respect to the other 41 brokers, FINRA found their customers “ended up with less liquidity and higher costs, since they traded cash for a product that locked them into a seven-year surrender period and for which many paid fees.” FINRA also took issue with the fact that “[t]hese customers all purchased the same VA and all allocated the entire amount of their investments into the fixed subaccount.”

    With respect to supervision, FINRA found that Fifth Third “did not use any VA-specific surveillance tools and approved virtually every VA transaction, including those that had been flagged for heightened review,” and concluded that Fifth Third’s “failure to maintain an adequate system and procedures to supervise its VA sales violated NASD Rule 3010.” Among the deficiencies specifically noted in the AWC are the following:

    • “failed to contact any of the affected customers [of the broker who had recently joined the firm] prior to approving the [exchange] transactions”
    • “the firm generally relied upon a transaction-by-transaction review of VA transactions by the PRD [Principal Review Desk]. It did not have in place a systematic analysis to identify possible unsuitable transactions. . . . [The] PRD did not employ any trend analysis of the transaction exceptions and other questionable conduct. . . . [T]he PRD . . . failed to . . . identify or respond adequately to patterns of potentially unsuitable VA transactions.”

    The AWC requires Fifth Third to pay a $1.75 million fine and $260,000 in restitution to customers for surrender charges they incurred and to offer rescission to all 197 customers. Fifth Third was also required to retain an independent consultant to review and recommend modifications to the firm’s supervisory systems and procedures and training.

    Sounding a consistent regulator theme in announcing the Fifth Third AWC, Susan Merrill, FINRA’s Chief of Enforcement, stated, “Variable annuities are complex investments that are designed to be retirement savings vehicles and are meant for the long-term investor.”7

    Guaranteed withdrawals

    The guaranteed withdrawal benefits offered by many variable annuities have become a popular feature in recent years; they have become particularly attractive given the performance of the stock market over the last year or so. These riders can provide a guaranteed income stream for life regardless of the performance of the annuity’s subaccounts. Two concerns about lifetime income riders have received attention from regulators recently: the possibility that “excess withdrawals” could cause the termination of the income guarantee under the terms of some annuities, and the risk that some annuity issuers might be financially unable to meet their income guarantee obligations.

    • A recent Wall Street Journal article noted the danger that an “excess withdrawal” may have the effect of terminating the guaranteed income feature of an annuity.8 An “excess withdrawal” is a withdrawal which causes the aggregate amount of withdrawals in a 12-month period to exceed the maximum annual withdrawal limit (usually expressed as a percentage of the base). Even in annuities with a so-called “no lapse” feature, “excess withdrawals” can terminate the guaranteed income benefit. The same day as the Wall Street Journal article, NAVA (f/k/a National Association for Variable Annuities) posted “Consumer Tips: Annual Annuity Withdrawals” on its website. A week later, FINRA’s Chairman and CEO, Rick Ketchum, commented on this issue in an address to the NAVA Government & Regulatory Affairs Conference.9 Mr. Ketchum stated that guaranteed withdrawal benefits “present a pitfall for consumers, one that the industry must address.” “In particular,” he said, FINRA is “concerned about those consumers who might inadvertently lose their guarantee due to a decline in their account balance.” He said that FINRA “expect[s] broker-dealers to provide disclosure [about the dangers of excess withdrawals] that is clear and meaningful.”10
    • The collapse of AIG and the concerns that recently have been expressed about the viability of financial institutions in general have caused some to wonder about the value of annuity guaranteed withdrawals benefits. Annuity issuers and some regulators have been quick to offer reassurances.11 And some regulators have been quick to insist that Chicken Little-like false alarms not be used to justify variable annuity exchanges.12 Assessment of issuer financial viability now more than ever must be part of the due diligence performed by the broker recommending a variable annuity with a guaranteed withdrawal feature, and by the firm principal reviewing such recommendations.

    An additional consideration prompted by variable annuity guaranteed income provisions is whether they can alter the suitability calculus for subaccount allocation. In other words, does the downside protection provided by these riders enable an annuity purchaser to be more aggressive in choosing his/her subaccount portfolio, e.g., to delay the move away from equities that has traditionally been recommended with advancing age? With many of these riders the appealing potential advantage of more aggressively investing the subaccount portfolio is the prospect of having the attendant opportunity for greater gain result in greater “ratcheting up” of the base amount on which the guaranteed income stream is then based.


    Member firms must review their existing processes and procedures and make the necessary adjustments to comply with Rule 2821. The required changes are likely to prove burdensome, expensive, and far from foolproof, and member firms that fail to adapt to the new rule will face dramatically increased regulatory and litigation exposure. It is quite possible that, as some critics fear, the increased expense, bother, and risk of doing variable annuity business under the new rule, in conjunction with the complication and uncertainly introduced by the other developments summarized above, will cause some firms to cease selling these products altogether.

    1 The amendments were approved by the SEC on April 15, 2009. Release No. 34-59772. The rule, as amended, with new “Supplementary Material,” is Attachment A to FINRA Regulatory Notice 09-32 (June 11, 2009), which is at http://www.finra.org/Industry/Regulation/Notices/2009/P118955.

    2 See FINRA Seeks to Delay the Effective Date of the Principal Review Provisions of its New Variable Annuity Sales Rule and Suggests That Further Review May be Warranted, Jan. 2, 2008 (available at www.bingham.com/Media.aspx?MediaID=6336), and FINRA’s New Variable Annuity Rule: Heightened Suitability, Supervision, Documentation, Training and Compliance Requirements, Sept. 24, 2007 (available at www.bingham.com/Media.aspx?MediaID=5744).

    3 FINRA Regulatory Notice 09-32.

    4 The amendments add the clarifying modifier “initial” before “subaccount allocations” in this provision. This does not appear intended to effect a substantive change: by its terms, the rule “does not apply to reallocations among subaccounts made . . . after the initial purchase or exchange of a deferred variable annuity.” Rule 2821(a)(1).

    5 See also FINRA Regulatory Notice 07-53, footnote 14, to the same effect. Rule 2821(b)(2) requires the recommending broker to make “reasonable efforts” to obtain information concerning the customer’s age, annual income, etc. Presumably an inquiry to the customer would constitute “reasonable effort” with respect to that information too, but neither the rule’s Supplementary Material nor Regulatory Notice 07-53 says that.

    6 Solely for the purpose of enabling firms to comply with the principal review requirement of Rule 2821(c), the SEC has granted broker-dealers exemptive relief from the prompt transmittal and net capital requirements of Exchange Act Rules 15c3-1 and 15c3-3. See SEC Release No. 34-56376 (Sept. 7, 2007). The exemption applies only if the variable annuity transaction is reviewed by a registered principal within seven business days, and, if approved, the customer check is forwarded to the insurance company by noon of the business day following the date of the principal review. The firm is required to keep a copy of each check and record the date the check was received and the date it was either transmitted to the insurance company (if the purchase is approved by the principal) or returned to the client (in the case of a rejection). The Release is available at: http://www.sec.gov/rules/exorders/2007/34-56376.pdf.

    7 April 14, 2009 News Release (available at www.finra.org/Newsroom/NewsReleases/2009/P118471). See also, e.g., New York Stock Exchange Information Memo No. 05-54 (Aug. 11, 2005), “Disclosures and Sales Practices Concerning Mutual Funds and Variable Annuities” at 5: “under normal circumstances, a variable annuity would not be appropriate as a short-term investment. . . . Customers should be able to hold a variable annuity product against all foreseeable cash needs at least until the expiration of the surrender charges . . .”

    8 “Annuity Fine Print: Guarantees Aren’t Always Guaranteed,” Wall Street Journal, June 1, 2009, p. R1.

    9 Mr. Ketchum’s speech is available at www.finra.org/Newsroom/Speeches/Ketchum/P118889. He also noted a concern with replacement of variable annuities that have “in the money” guarantees, stating that principals reviewing such replacements “must know the value of the guarantee and whether it is ‘in the money,’ and must evaluate the comparative guarantees of each product to ensure the replacement is suitable for the customer” (i.e., better or more valuable). No guidance was provided as to how firms are to place values on guarantees for the purpose of such a comparison.

    10 Note that FINRA Regulatory Notice 07-53 (in footnote 8) states that “a registered representative who merely delivers a prospectus to an investor ordinarily would not have a reasonable basis to believe that the customer has been instructed or educated — ‘informed’ — about the material features of a deferred variable annuity for purposes of” Rule 2821(b)(1). See generally SEC Release No. 34-56375 (Sept. 7, 2007) at 3 footnote 9: “The general suitability obligation [NASD Rule 2310] requires a broker-dealer to consider its customer’s ability to understand the security being recommended, including changes in the customer’s ability to understand, monitor, and make further decisions regarding securities over time.”

    11 See, e.g., California Dept. of Insurance Sept. 29, 2008 Press Release “Insurance Commissioner Poizner Warns AIG Policyholders to be Cautious if Approached to Replace Policies” (available at http://www.insurance.ca.gov/0400-news/0100-press-releases/0070-2008/release102-08.cfm); Massachusetts Office of Consumer Affairs & Business Regulation, Division of Insurance “AIG FAQs” (available at www.mass.gov/Eoca/docs/advisories/AIG_FAQs.pdf); Vermont Department of Banking, Insurance, Securities & Health Care Administration (“BISHCA”) website: “Vermont’s Insurance Guaranty Funds — How Vermonters are protected if an insurance company fails” (available at http://www.bishca.state.vt.us/InsurDiv/Consumer/advisories/advisory_guarantyassoc.htm); AXA Equitable website, “Why Choose AXA Equitable” (http://www.axa-equitable.com/axa/why-choose-axa-equitable.html). But see FINRA Investor Alert “Variable Annuities: Beyond the Hard Sell” (available at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/AnnuitiesAndInsur ance/P005976): “These guarantees are only as good as the insurance company that gives them. While it is an uncommon occurrence that the insurance companies that back these guarantees are unable to meet their obligations, it happens.” The SEC offers similar advice: “You may want to consider the financial strength of the insurance company that sponsors any variable annuity you are considering buying. This can affect the company’s ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, long-term care benefit, or amounts you have allocated to a fixed account investment option.” Investor Tips: “Variable Annuities: What You Should Know” (available at www.sec.gov/investor/ pubs/varannty.htm).

    12 See June 8 Ketchum speech: FINRA firm examination priorities continue to include “sales and supervision of variable annuities, particularly: . . . exchanges based on the perceived financial condition of the issuing insurance company.” See also, e.g., Iowa Commissioner of Insurance Bulletin 08-14 “AIG Insurance Companies” Sept. 23, 2008 (available at http://www.iid.state.ia.us/docs/bull0814.pdf), Massachusetts Office of Consumer Affairs & Business Regulation, 2008-14 “AIG Life and Annuity Insurers” Sept. 26, 2008 (available at http://www.mass.gov/?pageID=ocamodulechunk&L=4&L0=Home&L1=Government&L2=Our+Agencies+and+Divisions&L3=Division+of+Insurance&sid=Eoca
    &b=terminalcontent&f=doi_Bulletins_bulletins_08_14&csid=Eoca); Vermont BISHCA website: “Pressured to Cancel Your AIG Policies? Be Cautious about Replacing Annuities” (available at http://www.bishca.state.vt.us/InsurDiv/Consumer/advisories/advisory_guarantyassoc.htm).