United States: VA Switches: FINRA Disciplinary Action Reminds Firms About The Need For Adequate Supervisory Procedures

Last Updated: July 31 2014
Article by Daniel Nathan

In a case involving unsuitable variable annuity (VA) transactions, FINRA found that having good procedures and discovering improper conduct are not enough. A member firm must also ensure that it has adequate supervisory systems in place to ensure that its procedures are properly implemented. In this case, two of the firm's registered representatives—who were independent contractors—recommended and effected unsuitable VA transactions for their customers, causing their customers to pay unnecessary surrender fees on VAs that had only been held for two to three years, and incurring longer surrender periods on new VAs.

FINRA's facts and figures give a good sense of the seriousness of the conduct. One of the brokers switched 140 customers who held 214 fixed or variable annuities to a VA issued by an unaffiliated third-party insurance company, costing the customers approximately $208,000 in unnecessary surrender penalties and earning the broker $380,235 in commissions. The other broker switched 66 customers who held 87 fixed or variable annuities to the same unaffiliated VA, costing the customers approximately $155,173 in unnecessary surrender penalties and earning the broker $196,684 in commissions. As a result of each replacement transaction, the customer incurred a new surrender period.

It gets worse. FINRA found that the brokers employed a "one size fits all" investment strategy, notwithstanding the diversity of their customer base. Although the customers were between the ages of 27 and 73, some were working and some were retired, and they had varied net worths and income, the brokers classified all of their customers as having the same risk tolerance and primary investment objectives. In addition, the brokers switched substantially all of their customers into the same VA, the same rider, and the same asset allocation investment fund option.

FINRA fined the firm $100,000 and found that while the firm's written procedures generally addressed suitability considerations related to VA sales, its systems had the following deficiencies:

  • The firm failed to ensure that sales of VAs by these representatives adhered to its written procedures;
  • The supervisors approved VA replacements based on limited firm systems and with inadequate written guidance, computer systems, and surveillance tools;
  • The firm failed to verify the amount of surrender fees reported by its broker on replacement transactions, which were underreported; and
  • The firm also did not have a system or web-based access to a database that allowed it to adequately compare the annuity to be replaced with the other VAs.

FINRA also found that, as a result of the firm's limited systems, it was unable to identify the substantial volume of VA replacement activity for the brokers. The firm also did not identify trading trends in customer accounts, including when customers surrendered one VA and switched into the same VA; when customers purchased replacement VAs with substantially the same investment objectives and risk tolerance, asset allocation investment fund options, and riders; when VA replacement paperwork had substantially the same rationale for the replacement of the prior VA; and the existence of other red flags. FINRA noted that the two brokers were supervised remotely by firm managers.

The firm consented to the sanctions without admitting or denying the findings.

This was a relatively extreme case of sales practice abuses involving sales of VAs, but presents a good opportunity to remind member firms that FINRA continues to scrutinize procedures and practices with respect to the sales of VAs. FINRA has issued useful guidance over the years on supervision of VA sales, including Notice to Members 99-35, Notice to Members 96-86, and this compilation of guidance about compliance with suitability standards with respect to VAs and a broad range of complex products. Broker-dealers should continue to review their level of VA switching activity, look for red flags, and make sure that their systems and procedures are adequate to pick up outlier conduct on a routine basis.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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