Notwithstanding the SEC’s recently publicized shift away from “regulation by enforcement,” the practice appears alive and well when it comes to fixed indexed annuities (FIAs). In particular, the SEC’s continuing litigation in SEC v. Cutter seeks to expand registered investment adviser disclosure obligations to include the sale of FIAs by advisers who are also state-licensed insurance agents (adviser/agents), and SEC exams and investigations across the country are increasingly focused on disclosures made in connection with FIA sales by these adviser/agents.
In 2009, the SEC adopted Rule 151A under the Securities Act, which generally brought FIAs into the SEC’s regulatory sphere. That rule was short-lived, however, as the D.C. Circuit Court of Appeals vacated it in 2010, finding the SEC’s economic analysis supporting the rule to be “arbitrary and capricious.” Later in 2010, the so-called Harkin Amendment was included in the Dodd-Frank Act, which made clear that, subject to certain conditions, FIAs would not be subject to SEC regulation. The SEC then withdrew Rule 151A, effectively acknowledging that FIAs generally are not securities under federal law. But what the SEC could not achieve in 2009 through rulemaking, it now endeavors to do through enforcement.
Cutter
In SEC v. Cutter, the SEC charged Jeffrey Cutter, an adviser/agent, and his advisory firm with violations of the anti-fraud provisions of the Investment Advisers Act (Advisers Act). The SEC alleged that the defendants engaged in a “long-running, multi-faceted fraud scheme” to maximize Cutter’s income without disclosing the amount of compensation he received from the sale of FIAs to advisory clients. The SEC also alleged that several clients were not informed of the tax implications of Cutter’s advice to sell existing securities to invest in the firm’s model securities portfolios and that he made misrepresentations regarding his clients’ financial objectives and financial position in annuity applications. In short, the SEC argued that the defendants’ disclosures were not “full and fair” as required under the Supreme Court’s 1963 decision in SEC v. Capital Gains Research Bureau Inc. It is notable that Capital Gains is a 62-year-old case that preceded the relatively recent adoption of SEC Form ADV Part 2, which specifically details today’s disclosure requirements for advisers. It is also notable that Form ADV Part 2 — adopted decades after Capital Gains — does not require advisers to disclose to advisory clients the amount of compensation received by advisers from the sale of FIAs.
After a seven-day trial, the Cutter jury returned a verdict for the SEC on one count — a negligent violation of the anti-fraud rules — and a defense verdict on the more serious counts alleging reckless or knowing violations of the anti-fraud rules or a failure to implement reasonable compliance procedures. But the verdict form did not specify the conduct constituting negligence. Thus, the verdict may simply reflect the jury’s finding that the defendants were negligent in disclosing tax implications regarding the sale of existing securities or in accurately reflecting clients’ financial information in annuity applications, as mentioned above.
It is certainly not clear that the Cutter jury found the defendants negligent for not disclosing the amounts of compensation received from the sale of FIAs. But even if that were the case, it would be premised upon an expansive view of the fiduciary duty under the Advisers Act regarding disclosures of compensation arising from outside business activities that would implicate — and exceed — the duties of insurance agents to disclose such compensation under state law.
Cutter illustrates the problems of regulation by enforcement. To start, the SEC lacks statutory or regulatory authority to regulate the sale of FIAs generally, which is most appropriately viewed as simply an outside business activity in which many investment advisers engage. Indeed, there is a body of law that generally bifurcates federal securities regulation and state insurance regulation. Moreover, no SEC rule or form specifically requires disclosure of the amount of compensation received for the sales of FIAs. Thus, Cutter seems to present a classic regulation-by-enforcement case in which the extent of the fiduciary duty under the Advisers Act becomes a question of law to be decided by a district court, not by Congress or the SEC. As such, outcomes in similar cases may vary depending on the circumstances and the court, leading to inconsistent results.
Significantly, because the verdict did not specify the conduct the jury considered to be violative, it does not provide clear guidance, fair notice, or meaningful due process to the industry regarding the scope of the fiduciary duty under the Advisers Act. This uncertainty underscores the risks inherent in using enforcement actions to define regulatory obligations.
SEC Exams and Investigations
Several recent SEC exams and formal investigations have focused on records of disclosures and transactions involving the sale of FIAs by adviser/agents to advisory clients. These exams and investigations reflect the same enforcementdriven approach, notwithstanding the lack of statutory or regulatory authority to regulate the sale of FIAs.
Document Production Difficulties
Following requests for many types of FIA-related documents, SEC staff can often be surprised when an advisory firm says, “We do not have such records.” Indeed, SEC staff may not be aware that the sale of insurance products is governed by non-SEC rules and that advisory firms therefore seldom have certain types of records they seek. For example, all 50 states have adopted the National Association of Insurance Commissioners (NAIC) Model 275 as a “best interest” standard for insurers and insurance producers. That standard imposes care, disclosure, conflict-of-interest, and documentation obligations on producers, but allocates record-keeping responsibilities primarily to insurers.
Under the NAIC standard, disclosures must be made regarding the scope and terms of the relationship, the producer’s authority to sell the offered products, a description of the sources and types of cash and noncash compensation to be received, and a notice of the consumer’s right to request additional information regarding cash compensation. Notably, however, there is no requirement under the NAIC standard for producers to disclose the amount of cash compensation unless the consumer requests it. Producers must make written records of recommendations and their bases, but insurers typically maintain those records on the producers’ behalf.
Thus, investment advisory firms will not likely have many of the records that the SEC may seek regarding sales of FIAs by their adviser/agents. Such adviser/agents may have limited access to insurers’ websites, but their ability to obtain records will be governed by the producers’ contracts with the insurers. Other intermediaries involved in FIA marketing likewise generally do not maintain these records, which are held by insurers themselves.
Conclusion
For the reasons discussed above, the SEC’s claims in Cutter and its requests in exams and investigations that investment advisers provide certain records relating to FIA sales can fairly be characterized as regulation by enforcement. If the SEC truly disfavors regulation by enforcement, it should refrain from bringing such claims or requesting such documents until its remit to do so is made clearer.
