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Fun with FINRA: agents must educate, be educated, when selling variable annuities under new rules.

In February 2012, Lake county, Calif. life agent Glenn Neasham was sentenced to 90 days in prison for selling an indexed annuity to a woman in her 80s, whom the prosecutor claimed was unable to understand the product because she had early-stage dementia at the time of the sale in 2008. Neasham's license was revoked and, unable to support his wife and their four children, he lost the family home.

The Neasham case sent chills up the spines of life agents nationwide who also sell variable products. Of all the financial decisions that came to light in 2008 and afterward, why was one annuity sale with questionable suitability the top target for criminal prosecution?

Fast-forward to Feb. 4, 2013, a year after Neasham's conviction, when FINRA's new definition of suitability took effect. How will variable annuity sales be treated under revised Rule 2111?


Rule 2111 codifies and clarifies the three main suitability obligations that previously had been discussed largely in case law:

(1) "Reasonable-basis" suitability. A broker must perform reasonable diligence to understand the nature of the recommended security or investment strategy involving a security or securities, as well as the potential risks and rewards, and determine whether the recommendation is suitable for at least some investors based on that understanding.

(2) "Customer-specific" suitability. A broker must have a reasonable basis to believe that a recommendation of a security or investment strategy involving a security or securities is suitable for the particular customer based on the customer's investment profile.

(3) "Quantitative" suitability. A broker who has control over a customer account must have a reasonable basis to believe that a series of recommended securities transactions, taken together, are not excessive.

The new rule also broadens the existing list of customer-specific factors that firms and associated persons generally must attempt to ascertain and analyze when making recommendations to customers. The new rule adds a customer's age, investment experience, time horizon, liquidity needs and risk tolerance to the explicit list of customer-specific factors from the earlier rule (other investments, financial situation and needs, tax status and investment objectives).

The reference to the "investment strategy" is new, and according to FINRA, the term is to be interpreted broadly. It need not mention a specific security; the recommendation of a specific market sector can be an "investment strategy." Recommendations can also include advice to hold, purchase or sell current securities.

However, FINRA's interpretive material clarifies that silence by a broker is not a "recommendation" to hold a security. In contrast, former NASD Rule 2310(a) stated that when recommending "the purchase, sale, or exchange of any security," a member had to have "reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by the customer."

More generic communications may not be "recommendations." A communication that explains basic concepts such as diversification, inflation or asset classes is not a recommendation. An asset allocation model that is based on a generally accepted investment theory and is accompanied by appropriate disclosures does not constitute a recommendation.


But what about casual conversations with clients? Imagine the following discussion at a coffee shop:

Justin Case, licensed life agent and securities representative:

So, Fred, when are you going to leave the rat race and move to that cabin by the lake that you always talk about?

Fred Hurtz, engineer: I still talk about it, especially on days when the rats seem to be winning the race. But there are still 10 years to go on my mortgage. If anything happened to me, Zelda would need that money.

Justin: You know, Fred, there are variable annuities that provide a death benefit, so that in case you are "out of the picture" your beneficiary is guaranteed that your original money gets replenished, even if the investments held in the annuity have gone down. I'm selling that sort of annuity to a lot of folks in your situation, from a good company called Gangreen Insurance, the "GG20-20 policy." It lets you allocate the money into different classes, too, so you don't have all your eggs in one basket. If you'd care to drop by my office, I could show you an illustration.

Has Justin made a recommendation to Fred? Justin mentioned a specific product and described a few of its features, though not all of them. The new suitability rule could be stretched far enough to apply to this communication, though that would be an unrealistic and harsh standard for an impromptu and very preliminary marketing pitch.

What if Justin had gone a bit further in his salesmanship, and talked about a special "blend" of subaccounts that he recommends for all his variable annuity clients who are in Fred's age group? That would be a closer question because the conversation would have become quite specific, and at the level of a specific investment strategy based on Justin's own selection of subaccounts.


Even before the new definition of "suitability" went into effect, FINRA had required--and still does--special care in recommending purchases and exchanges of deferred variable annuities (DVAs) and recommended initial subaccount allocations (FINRA Rule 2330; the rule does not apply to reallocations nor to transactions in a tax-qualified or ERISA benefit plan).

In summary, Rule 2330 requires that the broker determine that the customer has been informed about DVAs in general, and specifically about surrender period charges; potential tax penalties for sales or redemptions before reaching the age of 59%; mortality and expense fees; investment advisory fees; potential charges for and features of riders; insurance and investment components; and market risks.

If a particular DVA is being recommended, the broker must reasonably believe that the customer understands the same features of that DVA and the recommended subaccounts, and they are suitable for the customer. Rule 2330 also applies when one DVA is being exchanged for another and imposes additional obligations on the broker.

To address the entirety of Rule 2330 would take several articles. Since our focus is on the initial "recommendation" to the customer, as that term is now redefined by FINRA, we will simply point out that there are also additional requirements for supervisory approvals, record keeping, training and other aspects of DVA transactions.


How can an individual agent or broker navigate between the rocky shoals of inadequate disclosure on one hand and potentially misrepresenting the terms of the variable product on the other? Simply reading the variable contract aloud, word for word, is impractical, and most customers would later say, "He lost me after the first paragraph."

FINRA provides some guidance as to how to communicate with the public about variable products (Interpretive Material IM-2210-2 on, but following that guidance does not inoculate the agent or broker against the claims of customers or beneficiaries.

The representative's best allies against such claims are the firm's compliance department and thorough, updated training provided by the firm. Checklists that are specific to the variable product and preapproved by compliance can be useful tools to help ensure that the key features of a given product have been discussed, including the potential benefits and the risks.

Variable life and variable annuity products are more complex than some other investments, less so than others. The role of the agent or broker is as much that of an interpreter as an adviser; the unique jargon of variable products can be daunting to a new customer. That's ironic in that the product can actually simplify the customer's overall financial health by creating a platform in which the product mix can readily be adjusted, without piledon commissions and charges, to meet changing needs or changing markets.

In FINRA arbitration proceedings brought by customers, one word in that last paragraph looms large: "commissions." The customer's allegation will invariably include an accusation that the agent/broker recommended a variable product only because the up-front commissions were larger than for mutual funds, stocks, bonds and some other products. The balance between the higher initial commission and the small or entirely absent commission and charges for changes in the variable product's subaccounts and allocations should be made clear from the outset and confirmed in writing, in a manner that the compliance department has approved.

In simplifying the customer's financial picture, the agent or broker needs to avoid "complex-ifying" his or her own. Understanding the lay of the regulatory landscape, receiving updated training and working together with the firm's in-house experts are the best ways to do so.

More on the Web:

* Certain Uncertainty

* When Wrecking Balls Strike

* Fiduciary: underrated risk?

Read these related articles at

FINRA Rule 2011 effective Feb. 4, 2013

(a) A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile. A customer's investment profile includes, but is not limited to, the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.

(b) A member or associated person fulfills the customer-specific suitability obligation for an institutional account, as defined in Rule 4512(c), if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a security or securities and (2) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member's or associated person's recommendations. Where an institutional customer has delegated decision making authority to an agent, such as an investment adviser or a bank trust department, these factors shall be applied to the agent.

Louie Castoria and Janene Marasciullo are partners in Wilson Elser's Securities practice, which Castoria co-chairs. Castoria is also chair of the firm's practice that defends agents and brokers, and he is chairman of the board of directors of the Insurance Educational Assn.
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Title Annotation:Avoiding E&O
Author:Castoria, Louie; Marasciullo, Janene
Publication:American Agent & Broker
Date:Mar 1, 2013
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