Kilpatrick Townsend

SEC Sanctions Registered Broker-Dealer in First-Ever Section 11 Enforcement Proceeding

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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If you have any questions about Section 11, or about the regulation of RIAs, broker-dealers, and registered investment companies generally, please feel free to contact us.

By the Investment Management and Broker-Dealer Teamat Kilpatrick Townsend & Stockton

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[i] See SEC, Press Release, SEC Charges RiverSource Distributors with Improper Switching of Variable Annuities (May 25, 2022), https://www.sec.gov/news/press-release/2022-89 (hereinafter, “Press Release”); In the Matter of RiverSource Distributors, Inc., SEC Release No. 34-94978 (May 25, 2022), https://www.sec.gov/litigation/admin/2022/34-94978.pdf (hereinafter, “Order”).

[ii] Press Release.

[iii] Press Release.

[iv] See Press Release; Order at 2.

[v] Order at 2.

[vi] Order.

[vii] Order at 3.

[viii] The Order provided that color-coding of compensation amounts depended on whether, and how long, the annuity contract had been out of the surrender period. For annuity contracts that had been out of the surrender period for longer, the representatives may receive more compensation. If the annuity contract was still in the surrender period or had not been out for long enough, their compensation would be less. Order at 3.

[ix] At a June 2017 meeting, one of the Broker-Dealer’s wholesalers presented to members of the wholesaling department with instructions on how to create an “in-force” annuity list. An additional training was provided by a wholesaler at a January 2018 national sales conference for wholesalers. Order at 3.

[x] Order at 3.

[xi] According to the Order, the Broker-Dealer’s variable annuity exchanges increased from $671 million and $768 million in 2015 and 2016, respectively, to $1,006 million and $1,049 million in 2017 and 2018, respectively. After the variable annuity exchange practice was identified by the Broker-Dealer’s compliance department, the exchanges decreased from $1,049 million in 2018 to $838 million in 2019. Order at 4.

[xii] Order at 4.

[xiii] Order at 4.