In a recent administrative order (the “Order”), the Securities and Exchange Commission (the “SEC”) charged a registered broker-dealer (the “Broker-Dealer”) with improper switching or replacing of variable annuities in violation of Section 11 of the Investment Company Act of 1940.[i] The Order stands as the SEC’s first-ever enforcement proceeding under Section 11 of the Investment Company Act of 1940 (“the Investment Company Act”).[ii] According to the Deputy Director of the SEC’s Division of Enforcement, Sanjay Wadhwa, the purpose of Section 11 of the Investment Company Act is “to prohibit the improper ‘switching’ of investors from one investment to another for the purpose of generating additional selling charges.”[iii] This Order directly addresses this issue.

A summary of the Order and some key takeaways are set forth below.

Summary of the Order

On May 25, 2022, the SEC released the Order, finding that the Broker-Dealer, which acted as a principal underwriter of variable annuities, engaged in sales practices which involved improper switching or replacing of variable annuities.[iv] The Order describes variable annuities as “complex securities generally considered long-term investments.”[v] Variable annuities entitle customers to payments that vary over time depending on considerations such as the terms of the contract and the performance of the portfolio. Typically, variable annuities require that the customer pay a fee for selling or exchanging their annuity contract if done before the end of the surrender period.[vi]

According to the Order, the Broker-Dealer offered and sold variable annuities to retail investors through an affiliated broker-dealer/investment adviser, and the Broker-Dealer employed wholesalers that assisted its affiliate’s representatives in understanding the complex securities. These wholesalers received commissions from the sale of the variable annuities underwritten by the Broker-Dealer.[vii]

According to the Order, certain of the Broker-Dealer’s wholesalers developed a sales practice where they created lists of variable annuities still in effect and owned by the Affiliate’s customers and identified exchange opportunities, including potential commissions that could be earned.[viii] According to the Order, the Broker-Dealer gave some wholesalers training on how to make and use these lists, referred to as “in-force” annuity lists.[ix] Some of the “in-force” lists were color coded, showing which variable annuities would result in a higher commission for the Broker-Dealer and the wholesaler.[x] From January 2017 to May 2018, some of the Broker-Dealer’s wholesalers offered (both in-person and virtually) holders of variable annuities exchange offers, which led to certain individuals exchanging their variable annuities. The Order states that holders’ exchanging of these variable annuities resulted in a substantial increase in the value of annuity exchanges made during the period, as well as an increase in the commissions for the wholesalers.[xi]

The Broker-Dealer’s compliance department became aware of these practices around March 2018 at which time they conducted an investigation, ultimately reprimanded those who were involved, and implemented remediation efforts, which included wholesaler trainings.[xii]

The Order concludes that the Broker-Dealer willfully violated Section 11 of the Investment Company Act, which prohibits principal underwriters from making or causing to be made an offer to exchange the securities of registered unit investment trusts (which includes variable annuities) unless the terms of the offer have been approved by the SEC or fall within limited exceptions.[xiii] The Order states that the SEC did not approve the alleged exchanges done by the Broker-Dealer and there were no applicable exceptions, making the sales in violation of Section 11.

Sanction

The Broker-Dealer was ordered to cease and desist, was censured, and was ordered to pay a fine of $5 million.

Takeaways

• Registrants should ensure that their compliance departments are actively involved in company oversight and are asking probing questions surrounding material increases in business activity, particularly with respect to business activities that generate higher commissions or fees.
• Compliance departments should pay close attention to a registrant’s practices involving variable annuities and other securities that often attract regulatory scrutiny (e.g., direct participation programs such as non-traded REITs). The Order, being the first enforcement proceeding under Section 11 of the Investment Company Act, may be a sign that the SEC is increasing its scrutiny on these types of transactions that result in higher commissions or fees for registrants.
• When designing firm policies, procedures and internal controls, firms should pay careful attention to pay structures that include commissions, as they pose a higher risk of fraudulent or improper activity.

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