FEND Securities Expert Witness
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Mason Alan Dinehart III Arbitrator - FEND Securities Expert Witness

LEGAL DUTIES OF STOCKBROKERS

 

VARIABLE ANNUITIES

 

FIXED INDEX ANNUITIES

 

1. FAIR DEALING – A stockbroker has a fundamental responsibility for fair dealing. The securities industry requires a stockbroker to treat his customer in a fair and honest manner. Stockbrokers are also subject to the rules of self-regulatory organizations such as the National Association of Securities Dealers (NASD). For example, the NASD Rules of Fair Practice impose the following standard upon brokers: "A member, in the conduct of his business shall observe high standards of commercial honor and just and equitable principles of trade." This standard, along with other NASD rules is legally enforceable as the standard to which investors are entitled to depend.  The cornerstone of this ethics rule is Rule 2110.  The basis of this rule is nothing less than Section 15A of the Securities Exchange Act of 1934 which requires the NASD, as a registered securities association, to have and enforce rules that "promote just and equitable principles of trade".  One court has suggested that Rule 2110 is to ensure "professionalism". The SEC has commented that the rule gives the NASD authority to impose sanctions for "moral standards" even if there is no "unlawful" conduct.  The NASD itself has stated that it applies when there is "bad faith".  Rule 2110 is/has been applied to numerous types of securities related activities, whether or not there is a violation of a more specific, companion provision of the NASD rules.  For example, in one decision, Alaska securities regulators found that the broker had violated the rule by 1) having a customer sign and date a blank new account form; 2) delaying (for three weeks) the execution of the investment program to which the customers had agreed; 4) failing to return phone calls of the customer promptly to discuss concerns of the customer; and 5) failing to promptly notify the firm's compliance department and keep it informed.  Brokers also have violated Rule 2110 when they have:  Sold securities that were neither registered nor exempt from registration: Sold securities pursuant to private placement memoranda that contained material misrepresentations and omissions; Improperly withheld customer funds and "deliberately" took advantage of an unsophisticated customer; Recommended purchase of speculative warrants; Failed to disclose the solicitation of outside business activities; Induced an elderly customer to make a large, unsecured loan; Delayed refunding customer funds to customers; Forged signatures on documents; and Used customer funds for personal benefit rather than the customer's benefit.  Obviously, Rule 2110 does have a significant reach.

 

     Another example of bad faith is fraudulent concealment. The elements of fraudulent concealment are: (1) the respondent must have concealed or suppressed a material fact; (2) the respondent must have been under a duty to disclose the fact to the claimant; (3) the respondent must have intentionally concealed or suppressed the fact with the intent to defraud the claimant; (4) the claimant must have been unaware of the fact and would not have acted as he did if he had known of the concealed or suppressed fact; and (5) the claimant must have sustained damages as a result of the concealment or suppression of the material fact.  See Marketing West, Inc. v. Sanyo Fisher (USA Corp. 6 Cal. App. 4th 603, 612-13 (1992).

 

     In California, there are four circumstances in which non-disclosure or concealment may constitute actionable fraud: (1) when the respondent is in a fiduciary relationship with the claimant (2) when the respondent has exclusive knowledge of material facts not known to the claimant; (3) when the respondent actively conceals a material fact from the claimant; and (4) when the respondent makes partial representations but also suppresses some material facts. LiMandri v. Judkins, 52 Cal. App. 4th 326,336 (1997).

 

2. FIDUCIARY DUTY - THE DUTY OF LOYALTY – Fiduciary Duty is the responsibility of care, disclosure and loyalty that a broker/brokerage firm has the obligation to provide to its customers.  Brokerage firms and brokers then owe this fiduciary duty to their customers. See Duffy v. Cavalier (1989) 215 Cal. App. 3d 1517 at p. 1533, 264 Cal. Reptr. 740,751; Hobbs v. Bateman Eichler, Hill Richards, Inc. (1985) 164Cal. App. 3d 174, 201-202, 210 Cal. Reptr. 387, 403-404.  See also, e.g. , Conway v. Icahn & Co.,  1616 F. 3d 504 (2nd Cir. 1994)  (finding that the relationship between a stockbroker and the customer is that of principal and agent and is fiduciary in nature).  See, also, Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P. 2d 508 (Colo. 1986).  A  fiduciary relationship exists when one person is under a duty to act for or give advice for the benefit of another upon matters within the scope of the relationship.  See Wolf v. Superior Court (2003), 107 Cal.App.4th, 25, 29:  "A fiduciary relationship is 'any relation existing between parties to a transaction wherein one of the parties is in duty bound to act with the utmost good faith for the benefit of the other party.  Such a relation ordinarily arises where confidence is reposed by one person in the integrity of another, and in such a relation the party in whom confidence is reposed, if he voluntarily accepts or assumes to accept the confidence, can take no advantage from his acts relating to the interest of the other party without the latter's knowledge or consent.......' "   A fiduciary relationship can arise when one party occupies a superior professional, business, or personal relationship.  Moses v. Diocese of Colorado,  863 P.2d 310 (Colo. 1993).  "The elements of a cause of action for breach of fiduciary duty are: (1) the existence of a fiduciary duty; (2) the breach of that duty; and (3) damage proximately caused by that breach."  (Mosier v. Southern Cal. Physicians Ins. Exchange (1998) 63 Cal. App.4th 1022, 1044: Stanley v. Richmond (1995) 35 Cal. App.4th 1070, 1086).  See City of Atascadero v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 68 Cal. App. 4th 445, 483 (1998).  To be charged with a fiduciary obligation, a person must knowingly undertake to act on behalf and for the benefit of another, or must enter into a relationship which imposes that undertaking as a matter of law.  See City of Hope Nat. Medical Center v. Genentech, Inc., 43 Cal. 4th 375, 385 (2008).  Although a fiduciary relationship may not exist based upon the legal relationship, one may exist based on the factual circumstances of their relationship.  See Persson v. Smart Inventions, Inc. 125 Cal. App. 4th 1141, 1159-62 (2005).  Because stockbrokers make their money through commissions, an inherent conflict can exist between the broker’s interests and those of the customers. However, the brokers must always place the interests of the customer first. This fiduciary duty to the customer must be paramount. For instance, trading frequently can become an issue. The broker should only recommend trades that meet the needs of the customer, not merely those that generate commissions for himself. Excessive trading by a broker for the sake of increasing commissions is known as "churning" and is illegal.  This obligation to refrain from acquiring any interest adverse to that of a principal precludes the agent from personally benefiting from secret profits, competing with the principal or obtaining an advantage from the agency for personal benefit of any kind.  The broker must treat the client with utmost care.  The agent is bound to the higher standard of a professional in the field which extends the standard of duty to investigate within the profession, to ensure the maximum protection and information be provided to the principal.  The agent must act with integrity.  That is he must display soundness of moral principle and character and demonstrate fidelity and good faith.  This duty  includes total truthfulness and prohibits any advantage over the principal obtained by the slightest misrepresentation, concealment, threat or adverse pressure of any kind.  This would be especially true with respect to recommending the sale of proprietary products to customers i.e. securities sold out of the inventory of, and or manufactured by the broker's securities firm.  The above obligations define the most important responsibility of a broker to his client...fiduciary duty.  In Moak v. Sloy, a private arbitration in Oregon on 9-26-02, concerning a sophisticated investor's non-discretionary concentrated technology portfolio, the arbitrators unanimously awarded the claimant multi-million dollar damages against the broker/CFP.  The panel stated in its 13 page opinion "Mr. Sloy was a certified financial planner who worked exclusively for high net worth clients.  Mr. Sloy earned substantial compensation from Moak and others in exchange for the benefit of his training and financial acumen.  Mr. Sloy was, in short, well paid to be a gatekeeper, not a cheerleader for prevailing market sentiment or foolhardy strategies proposed by his clients".  The (broker's fiduciary duty is to "manage the account as dictated by the customer's needs and objectives, to inform of risks in particular investments, to refrain from self-dealing, to follow order instructions, to disclose self-interests and to stay ahead of market changes")  PaineWebber, Inc. v. Vorhees, 891 S.W. 2d, 126,130 (MO 1995).  Should there be any doubt of the brokers fiduciary duty in all cases, consider the following;  in the matter of Lawrence R. Leeby, Exchange Release No. 3450, 13 SEC 499, 1943 WL 29813 (1942).  While the cases that discuss and found the fiduciary relationship to exist may have arisen under factual circumstances involving churning, nondisclosure and improper advise, among others, whereas only a failure to follow a customer's instructions is present herein, it is submitted that the nature of the fiduciary relationship is nevertheless unchanged and applicable, and that only the scope of the fiduciary duty may be affected.  In August, 2003,  an administrative complaint was filed by the Massachusetts Securities Division against Morgan Stanley DW, Inc. (No. E-2003-53) for placing pressure on brokers and managers to push proprietary mutual funds (Partnered and Van Kampen) on a basis that "amounted to extortion". In addition to the 12b-1 fees, an extra 10% was paid for the sale of these funds, plus additional bonuses and not disclosed to clients. This relationship exists whenever trust and confidence is reposed by one person in the integrity and fidelity of another.  A fiduciary relationship requires one to exercise the utmost good faith and fair dealing when acting on another's behalf.  See Leboce v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 709 F.2d. 605,607 (1983), Vulcinich v. Paine, Webber, Jackson & Curtis, Inc., supra, Duffy v. Cavalier, 215 Cal. App. 3d 1517 (1989), Mars v. Wedbush Morgan Securities, Inc., 231 Cal. App. 3d 1608 (1991), Pedott v. Goldinger, 1998 U.S. Dist. LEXIS 4259 (1998).  The Wall Street Journal put it succinctly on January 9, 2004 when it stated, "Under securities laws, brokers are held to the high standard of trusted financial advisors, not just salespeople, and must either offer objective advice or properly disclose any serious conflicts".  The statute of limitations for breach of fiduciary duty is four years.  (Code of Civil Procedure # 242;David Welch Co., v. Erskine & Tulley (1988) 203 Cal. App. 3d 884,893 ("[W]here a cause of actions is based on a defendant's breach of fiduciary duties, the four-year catchall statute set forth in code of Civil Procedure, section 343 applies.")  Where a fiduciary obligation is present, the courts have recognized a postponement of the accrual of the cause of action until the beneficiary has knowledge or notice of the act constituting a breach of fidelity.  (United States Liab. Ins. Co. v. Haidinger-Hayes, Inc. (1970) 1Cal.3d 586, 596; Sherman v. Lloyd (1986 181 Cal. App.3d 693,698; Schneider v. Union Oil Co. (1970) 6 Cal. App.3d 987, 994).  The existence of a trust relationship limits the duty of inquiry.  "Thus, when a potential plaintiff is in a fiduciary relationship with another individual, that plaintiff's burden of discovery is reduced and he is entitled to rely on the statements and advice provided by the fiduciary." (181 Cal. App.3d at p. 699, and "[s]ince [plaintiff] was in a fiduciary relationship with [defendant], he was entitles to rely on [defendant's] statements concerning the propriety of the investment structure.  As such, [plaintiff's] cause of action did not accrue until he learned that the investment structure may have been improperly created." (Hobbs v. Bateman Eichler, Hill Richards, Inc. (1985) 164 Cal. App.3d 174Id at pp. 201-202).  Where the plaintiff is not under such duty to inquire, the limitations period doesnot begin to run until plaintiff actually discovers the facts constituting the cause of action, even though the means for obtaining the information are available. (Hobart v. Hobart Estate Co. (1945) 26 Cal.2d 412, 438)   The distinction between the rules excusing a late discovery of fraud and those allowing late discovery in cases "in the confidential relationship category is that in the latter situation the duty to investigate may arise later by reason of the fact that the plaintiff is entitled to rely upon the assumption that his fiduciary is acting in his behalf" Bedolla v. Logan & Frazer (1975) 52 Cal.App.3d 118, 131); also see Eisenbaum v. Western Energy Resources, Inc. (1990) 218 Cal. App.3d 314. In PaineWebber, Inc. v. Voorhees, 891 S.W.2d 126, 130 (MO 1995) The Supreme Court of Missouri unanimously ruled that, " stockbrokers owe customers a fiduciary duty.  The Court said that this fiduciary duty includes at least these obligations:  to manage the account as dictated by the customer's needs and objectives; to inform of risks in particular investments; to refrain from self-dealing; to follow order instructions; to disclose any self-interest; to stay abreast of market changes; and to explain strategies".  See also these cites indicating that in making recommendations, brokers occupy a fiduciary status - Robert Joseph Kernweis, 2000 WL 33299605 at FN 82 (N.A.S.D.R.2000); John M. Reynolds,50 SEC Docket 624, 630 (Dec. 4, 1991); Dale E. Frey, 79 W.E.C. 1727, 2003 WL 245560 at *23 (2003).

 

     Brokers are professionals, not just salesmen.  Hermann v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 17 Wash. App. 626,630,564 P.2d 817 (1977)

 

     A broker/dealer owes a fiduciary to a retail customer "[T]he duties of a securities broker are, if anything, more stringent than those imposed by general agency law.  All that is necessary [to show fraud based on those duties] is to hold defendant to standards that would govern an agent for the sale of potatoes."

 

     The prospectus defense does not apply to defeat a claim for a breach of fiduciary duty cause of action because this action does not require reliance as an element.  The elements of a cause of action for breach of fiduciary duty are (1) the existence of a fiduciary duty; (2) the breach of the fiduciary duty; and (3) damage proximately caused by the breach.  Stanley v. Riicmond, 41 Cal Rptr. 2d 768,776 (Ct. App. 1995); see also Brown v. Brewer, 2009 U.S. Dist.LEXIS 47535 at #7-8(C.D. Cal. May 29, 2009); Malone v. Briincat, 722 A.2d5,12 (Del. 1993) (stating that causation is not an element of an action for breach of the fiduciary duty of disclosure).

 

     Regarding the lack of reliance required in a fiduciary obligation, one noted commentator has explained:

 

         This missing element of reliance is perhaps one of the more interesting and often misunderstood aspects of the fiduciary obligation.  Although many cases discuss the question of whether such reliance was reasonable under the circumstances, the fiduciary relation does not require reliance, reasonable or otherwise.  one scholar expressed this point quite clearly when he wrote, "the law entitles the entrustor to rely on the fiduciary's trustworthiness.  The entrustor is therefore not required to show that he actually relied on the fiduciary and the fiduciary has the burden of justifying self-dealing transactions.  Cecil j. Hunt, II, The Price of Trust: An Examination of Fiduciary Duty and the Lender-Borrower Relationship, 29 WAKE FOREST L. REV. 719, 731 (1994) (citing Tamar Frankel, Fiduciary Law, 71 CAL. L. REV. 795, 824-25(1983) (emphasis added).  And Professor Joseph Long, a leading commentator on blue-sky laws, explained:  "The investor has no due diligence obligation to make any investigation concerning the investment or to verify any information.  The Securities Act was intended to reverse the age-old concept of caveat emptor and replace it with the concept of caveat venditor (or seller beware).  Therefore, the investor is not charged with information which he might have acquired or with constructive knowledge.  In construing California's Blue Sky Act (known as Corporate Securities Law section 25000, California courts have consistently concluded that reliance is not an element.  In Bowden v. Robinson, 136 Cal. Rptr. 871, the court stated that sections 25400 and 25500 :"conspicuously avoid the requirement of 'actual reliance'.  The legislature is again expressing its intention to afford the victims of securities fraud with a remedy without the formidable task of proving common law fraud [which requires reliance].

 

3. DISCLOSURE – A broker also has a duty to disclose all material information related to an investment recommendation. In California, this duty is valid, irrespective of the sophistication of the investor, Duffy v. Cavelier, 215 Cal. App. 3d 1517, 1533 (1989)! The California Supreme Court held that where there is a duty to disclose, the disclosure must be full and complete, and any material concealment or misrepresentation will amount to fraud.  See Neel v. Magana, Olney, Levy, Cartwright & Gelfand, 6 Cal. 3d 176, 188-89 (1971).  This means all information that may be reasonably relevant to an investor in making an informed investment decision. Also, a broker has an obligation to disclose the various risks of an investment recommendation. It is the settled law of California and elsewhere, that "[Where] there exists a relationship of trust and confidence, it is the duty of one in whom the confidence is reposed to make full disclosure of all material facts within his knowledge relating to the transaction in question and any concealment of material facts is a fraud." Estate of Shay (1925) 196 Cal. 355,365; Martin v. Martin (1952) 110 Cal. App.2d 228, 233; Daily v. Superior Court (1935) 4 Cal. App.2d 127, 131-132) "Where there is [such] a duty to disclose, the disclosure must be full and complete, and any material concealment or misrepresentation will amount to fraud sufficient to entitle the party injured thereby to an action." (Stafford v. Schultz (1954) 42 Cal.2d 767,777; Pashley v. Pacific Elec. Ry. Co. (1944) 25 Cal. 2d 226, 235; and see Kruse v. Miller (1956) 143 Cal. App. 2d 656, 659-660).  California law defines deceit to include "the suppression of a fact, by one who is bound to disclose it, or who gives information of other facts which are likely to mislead for want of communication of that fact. "Cal. Civ. Code #1710.   In California, there are four circumstances in which non-disclosure or concealment may constitute actionable frand:  (1) when the defendant/respondent is in a fiduciary relationship with the claimant/plaintiff; (2) when the respondent/defendant had exclusive knowledge of material facts not known to the plaintiff; (3) when the defendant/respondent  actively conceals a material fact from the plaintiff/claimant; and (4) when the defendant/respondent makes partial representations but also suppresses some material facts.  KuNabdru v, Hydjubsm 52 Cal. App. 4th 326 336 (1997).

 

     Brokers must be truthful in all communications with customers. Nothing material may be left out of these communications with investors.  A fact is material if  "a reasonable investor might have considered [it] important in the making of [his] decision."  Affiliated Ute Ccitizens v. United States, 406 U.S. 128, 153-54 (1972).  Materiality is a fact-specific issue that is ordinarily left up to the trier of fact, see  in re Apple Computer Secs. litig., 886 F.2d 1109, 1113 (9th Cir. 1989) cert. denied, 496 U.S. 943 (1990).  Essentially, their communications should provide a sound basis for evaluating any recommended securities. Exaggerated, false or misleading statements are flatly prohibited.  When a registered representative recommends the purchase or sale of a stock to a customer, he or she must not only avoid affirmative misstatements, but must also disclose material adverse facts about which the salesperson is, or should be, aware.  Particular care should be taken with respect to the accuracy and completeness of information concerning low-priced, speculative securities.  In this connection, members should focus on the completeness of disclosure concerning securities issued by companies whose ability to operate as a going concern is subject to question or contingent on gaining additional financing.  This includes disclosure of any conflicts of interest that could influence the salesperson's recommendations or the customer's decision to purchase or sell the security. (NASD Notices to Members # 96-32 & # 96-60)  Additionally, brokers on occasion receive extra compensation for emphasizing certain products.  Examples would be the firm's own proprietary products or certain mutual funds during IRA season!  Several mutual funds offer full dealer re-allowance to highlight a new fund or raise sales early in the year as investors beef up their IRA's to reduce their tax bills.  Here is how re-allowance works:  Funds that use a broker to sell their shares usually add a sales charge, or "load", either at the time of sale or later.  The majority of that money goes to the brokerage firm and the broker's commission.  But a portion, usually between 0.25% and 0.50% of the money invested, goes to the fund company.  When the company offers full dealer re-allowance, however, it pays that money to the brokerage firm, which may share the windfall with its brokers.  Customers usually aren't told about such added commissions unless they ask, whereby it can be argued that these incentives can tempt brokers to choose personal gains over a client's best interest.  Since this re-allowance doesn't result in an additional fee to the investor, many are unaware of this incentive.  It is usually only disclosed in the small print - securities regulators require that these deals be noted in a fund's prospectus or statement of additional information.  In the Spring of 2002, mutual fund families offering such dealer incentives included MFS Investments, Oppenheimer Funds, and Zurich Scudder Investments.  Best practice brokers should always disclose these sales incentives to their customers to uphold their responsibilities of fair dealing.  An agent has a duty "to disclose to the principal all material facts fully and completely.  A fact is material...if it is one which the agent should realize would be likely to affect the judgment of the principal in giving his consent to the agent to enter into a particular transaction on the specified term "[Citation]" (Rattray v. Scudder (1946) 28 Cal.2d 214, 224; Jorgensen v. Geach 'N' Bay Realty, Inc. 1981 125 Cal.App.3d 155,162).

 

     The full extent of these disclosure duties and obligations are delineated by the broker/dealers' industry organization, the Securities Industry Association (SIA) an association of over 600 member firms which states that its members are obligated to:

 

     *  inform customers of clear measures of risk for a specific time period;

 

     *  know the customer's objectives and risk tolerances;

 

     *  apprise the customer of significant conflicts of interest identified in a financial relationship between an investor and his or her broker-dealer or account representative;

 

     *  provide the customer with professional assistance to help clarify investment goals and risk tolerance; and

 

     *  present reasonable investment alternatives designed to meet those expectations, and disclose the comparative risks, benefits, and costs*.

 

And that customers are entitled to:

 

     *costs and fees (and their effect) that are clearly stated;

 

     *  receive competent and courteous service and advice;

 

     *  be provided with responsible investment recommendations based on personal objectives, time horizon, risk tolerance, and other factors; and

 

     *  rely on the firm's assistance in setting realistic expectations about the long-term performance and associated risks of various securities

 

*  See SIA Best Practices, Investor Rights (emphasis supplied).

 

4. CONTROL/TRADING AUTHORIZATIONS - In non-discretionary accounts, it is critical to determine who is in control of the trading in the account.  There are a number of factors that determine who is in control of the account, the broker or the client.  Direct Control - This may exist in a non-discretionary account where the broker has been servicing the customers account for a long period of time, actively advising, communicating frequently, and providing data and research reports concerning various companies and where the customer has regularly relied and acted upon the broker's advice and information.  Indirect Control - The "naive" or inexperienced, unsophisticated investor does not have the ability to understand the difference between various available investment vehicles (e.g. common or preferred stocks, bonds, options, commodities, etc.) and has difficulty understanding the difference between various types of accounts, or is unable to comprehend investment advice, therefore making him dependent upon his broker.  This type of relationship often occurs in a situation where there exists a close personal or familiar relationship between the customer and his broker.  Effective control of an account can exist, then, without formal discretionary authority.  This can occur even if the client is consulted before every transaction, but, for whatever reason (e.g. lack of sophistication or heavy reliance on the broker's judgment), almost always gives approval of proposed trades.  NASD - PUBLICATION, In the Matter of District Business Conduct Committee District No. 1 Complainant, v. Daniel Wright Sisson, Menlo Park, California, Respondent; BEFORE THE NATIONAL ADJUDICATORY COUNCIL.  NASD REGULATION, INC., (November 18, 1998),   "Sisson exercised de facto control over both KP's and ED's accounts during the periods in question.  As noted earlier, Sisson admitted that both customers habitually followed his recommendations and rarely took affirmative steps to direct the trading in their own accounts.  In fact, the evidence shows that neither KP nor ED was sophisticated or experienced enough to evaluate effectively Sisson's complicated strategy of purchasing high-yield securities using margin.  The finding that Sisson controlled ED's account is bolstered by the fact that the trading activity in the account changed little when RD, a sophisticated and active investor, died."

 

The law imposes additional extra-contractual duties on brokers who take unfair advantage to their customers' incapacity or simplicity.  Kwiatkowski, 306 F.3d at 1308.  These extra-contractual duties are imposed upon such brokers via the theory of de facto control.  De facto  control will be deemed to have occurred where, in reviewing the course of dealing between the parties, the circumstances are such as to effectively render the client dependent upon the broker.  Kwiatkowski, 306 F. at 1308.  These special circumstances exist where, for example the client has impaired faculties, or has a closer than arms-length relationship with the broker, or who is so lacking in sophistication that de facto control of the account is deemed to rest in the broker.  When de facto control is  exercised by the financial advisor, the broker clearly owes the customer not only a fiduciary duty with regard to each individual transaction but also owes a fiduciary duty, on an ongoing basis, to the total account, which includes all of the broad fiduciary duties that are owed by brokers handling discretionary accounts.  See Lieb v. Merrill Lynch, Pierce, Fenner & Smith, 461 F.Supp. 951, 954 (E.D. Mich. 1978); see also Kwiatkowski, 306 F.3d at 1308-9; Hecht v. Harris, 430 F. 2d 1202 (9th cir. 1970) Davis v. Merrill Lynch, Pierce, Fenner & Smith 906 F.2d 1206, 1216-17 (8th Cir. 1990).

 

In the matter of Saundra Logay, Administrative Proceeding, File No. 3-8969, Before the Securities & Exchange Commission; Initial Decision - Release No. 159 (January 28, 2000),  "A formal discretionary account is not needed to demonstrate control.  Mihara, 619 F.2d at 814; Newburger, Loeb & Co. v. Goss, 563 F.2d 1057, 1069-70 (2d Cir. 1977).  With respect to non-discretionary accounts, such as those discussed herein, factors establishing de facto control include whether the customer is able independently to evaluate the broker's recommendations and exercise independent judgment.  Follansbee v. Davis, Skaggs & Co., Inc., 681  F.2d 673, 676-77 (9th cir. 1982) (citing Mihara, 619 F.2d at 814; Hecht v. Harris, Upham & Co., 283 F. Supp. 417 (N.D. Cal. 1968); Eugend J. Erdos, 47 S.E.C. 985, 989-90 (1983), aff'd, 742 F.2d 507 (9th Cir. 1984)); see also Carras v. Burns, 516 F.2d 251, 259 (4th Cir. 1975)  ("The issue is whether or not the customer, based on the information available to him and his ability to interpret it, can independently evaluate his broker's suggestions.").  Some additional factors to consider in determining whether or not a broker controlled an investor's account include:  the investor's sophistication; the investor's prior securities experience; the trust and confidence the investor has in the broker; whether the broker initiates transactions or whether the investor relies on the recommendations of the broker; the amount of independent research conducted by the investor; and the truth and accuracy of information provided by the broker.  Stuart C. Goldberg, Fraudulent Broker-Dealer Practices, #2.8[b][1] (1978).  As Administrative Law judge Lillian a. McEwen noted, "I conclude that Zessinger (the broker) had de facto control over the accounts at issue.  Zessinger's customers were unsophisticated investors with little or no prior securities experience.  They did not understand their account statements and, except on the rarest occasions, never initiated transactions in their own accounts.  Lastly, when the customers did raise questions about Zessinger's trading, he told them that the account statements that caused them concern were inaccurate.  In short, the record clearly indicates that the reliance the investors placed in Zessinger, combined with their lack of understanding or experience in investment matters, resulted in his de facto control of their accounts.  See Mihara, 619 F2d at 821 (holding that control is established when the client routinely follows the recommendations of the broker); Hecht, 283 F. supp. at 433 (finding control can be inferred from evidence that the customer invariably relied on the dealer's recommendations, especially when the customer is relatively naive and unsophisticated); Carras, 516 F.2d at 259; Follansbee, 681 F.2d at 676-77.

 

In non-discretionary accounts, no unauthorized trading is permitted.  .

 

 – A broker may not execute any transaction in a customer’s account unless the customer has approved and authorized the trade in advance, or has given the broker power of attorney to make trading decisions in the account.

 

5. SUITABLE RECOMMENDATIONS – One of the most important duties for brokers is that all investment recommendations must be consistent with the customer’s financial & tax status, investment objectives, level of understanding and risk tolerance. Under the "suitability rule" and the "know your customer rule", a broker must reasonably believe that the recommendation is appropriate for that particular customer based upon his specific financial situation, understanding and needs. The stockbroker must create an up-to-date customer profile that matches the customer with the appropriate investment.  The investments selected do not determine investor suitability, the complete profile and risk tolerance of the customer does! (Notice to Members #96-60) See Resources - Suitability.

 

     A broker must refrain from making an unsuitable recommendation even if the customer expressed an interest in engaging in the inappropriate trade or asked the broker to make the recommendation.  See, e.g. ,Dane S. Faber, Exchange Act Release No. 49216, 2004 SEC LEXIS 277, at *23-24 (Feb. 10, 2004).

 

     On 12-02-02, in Washington, D.C., the NASD announced that it has censured and fined American Express Financial Advisors, Inc. for sales practice and supervision violations in connection with its sale of variable annuities and variable life products over a 30 month period, ending in 2000. NASD's review focused on American Express' sale of variable annuities into tax-qualified retirement plans and accounts.  The NASD fined American Express Financial Advisors $350,000 in connection with selling variable annuities into already-tax deferred retirement accounts such as IRA's and 401(k) plans.  The NASD found that American Express, through certain registered representatives, omitted material facts when selling variable annuities into qualified plans.  In making some sales, registered representatives failed to disclose that variable annuities do not provide a tax benefit or advantage of tax-deferred earnings when they are purchased for such plans.  In general, tax deferral is one of the primary reasons for purchasing a variable annuity.  In the sale of a variable annuity, to an account that is already tax deferred, sales should only be made when other benefits of a variable annuity such as a death benefit or annuity payout options support the purchase.  Some American Express representatives failed to determine that customers had a need for a benefit offered by a variable annuity, other than tax deferral, when recommending the purchase of the product.  Such sales were in violation of NASD rules since the registered representatives lacked a reasonable basis for believing that their recommendations were suitable.  In addition, in certain instances, American Express representatives did not adequately explain to customers, the costs and features of variable annuities.  They also failed to compare and contrast variable annuities with mutual funds in those instances where the customer's needs might have been better met through the purchase of mutual funds.  The NASD found that American Express had failed to address these issues adequately when it trained representatives and that certain disclosure documents omitted material facts regarding qualified annuities.  Mary L. Schapiro, NASD Vice Chairman and President of Regulatory Policy and Oversight stated that "We continue to see instances of abusive sales practices and suitability problems with variable annuities.  It is only through effective training and a comprehensive supervisory system that firms can ensure that customers receive important disclosures concerning these complex products and that they are sold only to customers for whom they are suitable."  Department of Enforcement - NASD Letter of Acceptance, Waiver and Consent NO. CAF020057, pursuant to Rule 9216 of the NASD Code of Procedure.  Ms. Shapiro reported that in March, 2004, Prudential was ordered to pay customers $9.5 million and a $2 million fine for variable annuity sales and switches that violated NY State Insurance Dept. regulations.  Waddell and Reed and two of its senior executives were also charged for recommending 6,700 variable annuity exchanges to its customers without determining the suitability of the transactions, generating $37 million in commissions and costing their customers $10 million in surrender fees.  Finally, along with 75 annuity-related disciplinary actions in the last three years, she reported that a Louisiana broker was permanently barred from the securities industry for unsuitable variable annuity sales.

 

     Not unlike variable annuities, the sale of Class "B" mutual funds have caused severe suitability problems.  On 2-12-04, Linsco/Private Ledger Corp. (SEC case # 3-11401) was sanctioned with a monetary fine of $1,116,402.50 as follows  "Respondent has submitted an offer of settlement without admitting or denying the findings, except as to the SEC's jurisdiction, and consented to the entry of this order.  The respondent sold shares issued by mutual funds without providing certain customers with reductions in front-end loads, or sales charges, also known as "breakpoint" discounts, described in the prospectuses of the funds.  According to data submitted to the NASD by respondent, respondent is estimated to have failed to give certain customers breakpoint discounts totaling approximately $2,232,805 during the relevant period.  By failing to disclose to certain customers that they were not receiving the benefit of applicable breakpoint discounts, respondent willfully violated Section 17(A)(2) of the Securities Act. Further, because respondent did not charge these customers the correct sales loads as set forth in the mutual funds' prospectuses, and also did not disclose in confirmations the remuneration respondent received from the sales loads charged to these customers, respondent willfully violated Rule 10B-10 under the Exchange Act".  On the same date, the NASD ( Case # CAF040005) obtained an Acceptance, Waiver & Consent from Linsco/Private Ledger Corp. and a  Monetary/Fine,Censure in the amount of $2,232,805.  The NASD sighted NASD Conduct rule 2110 - Respondent member sold shares issued by mutual funds without providing certain customers with the reduction in the front-end loads, or sales charges described in the prospectuses of the funds; failed to give its customers breakpoint discounts in 35.64% of eligible mutual fund transactions in 2001 and 2002, that resulted in missed breakpoints that would have reduced customers charges by approximately $2,232,805 on their purchases of mutual fund shares with front-end loads during the relevant period.

 

6.  DUTY TO DIVERSIFY - The Prudent Investor Principle - Diversification is essential to prudent investing.  One of the time honored investment maxims is that risk can be reduced by diversification.  The Nobel Prize in Economics was awarded to Harry Markowitz in 1990 for a rigorous explanation of this principle.  There is general agreement that a portfolio of investments is truly diversified only when it is made up of distinctly separate & broadly different asset classes (see  Diversification Chart - Suitability Defined & Explained)  It takes at least 50 stocks, spread among 5, usually 6 non-correlated asset classes to achieve adequate diversification and thereby reduce non-systemic risk.  This is firm-specific risk - the risk of one company causing a significant move, either up or down, in a portfolio (Modern Portfolio Theory - Edward Elton & Martin Gruber - 1987).  Even index funds alone do not assure that the diversification requirement is met.  In recent years a handful of stocks have moved the S&P 500, and, even more, the NASDAQ Composite Index.  In 1998 the top five stocks contributed 25% of the S&P 500 performance and 70% of the NASDAQ; the top ten stocks contributed 41% and 82% respectively!  These are not broad cross-sections of American industry, as was the case as recently as 1995, when the top ten in the S&P 500 only contributed 13% of the performance.  For real diversification today, international assets along with the Russell 2000 should be considered as well.  For diversification internationally, one need not look to foreign stocks alone.  American companies, as of year-end 2000, with their percentages of foreign earnings include; AIG (53%), Coca-Cola (82%), Gillette (63%), Intel (58%), Microsoft (37%) and Pfizer (49%).  As of February 2006, as reported in the Wall Street Journal, Morningstar reported that more than 100 mutual funds classified as U.S. stock funds now have more than 20% of their portfolios in non U.S.securities.

 

      William Sharpe, another Nobel Prize winner from Stanford University and creator of the Sharpe Ratio wrote in 1978," Diversification does reduce risk, and the reduction can be greater, the wider the range of possible investments".  The duties increase for the broker as fiduciary!  A fiduciary may invest in many things but he should not gamble.  Gambling may be defined as buying an asset without an  inherent, ascertainable underlying buildup of value through earnings or interest.  It is clear that a fiduciary must diversify unless it is clearly "prudent" not to!  In the absence of specific authorization to do otherwise, a conscious concentration and lack of diversification would constitute a serious breach of fiduciary obligation.  Further, breach of the duty to diversify constitutes an independent basis of liability, separate from a breach of the general duty of prudence (Liss v Smith, 991, F. Supp. 278,301 (SDNY, 1998)).  Diversification is uniformly acknowledged to be a pre-requisite of a well managed account.  Anything that deviates from that expected treatment of a customer must be justified by the broker.  The decision to concentrate a portfolio in only one asset class, and not diversify, must be fully grounded in the broker's research, into (a) the portfolio design and (b) the specific securities selected.  It is not sufficient simply to have a reasonable basis for recommending a concentration of securities in only one asset class, rather the broker/fiduciary must also have reasonable grounds for deviating from the norm of prudent investing!  If a broker/fiduciary chooses to sell securities where there is a conflict with his own firm i.e. proprietary products, the required justification is even greater.  The broker must make a reasonable determination that because of "special circumstances" it is more prudent not to diversify.  Note that the test is prudence, not whether the broker thinks he can make more profits by not diversifying, but whether it is more prudent to forego the protection and risk diminution afforded by diversification.  Note also, that the language "reasonable determination" implies an objective standard, not just the subjective opinion of the broker.  For a fiduciary then, the threshold is even higher.  A fiduciary must have a compelling reason not to diversify i.e. it must be "clearly prudent not to do so".  Furthermore, prudent management is evaluated on an ongoing basis.  Even if the broker may have had reasonable grounds at the outset, retaining the investments & increasing the concentration may become imprudent later.  True diversification does not promise that the portfolio will outperform the market, only that it will be intelligently designed for the investor’s financial circumstances.  According to the Management of Investment Decisions (1996), breaches of fiduciary duty due to lack of diversification generally fall within 3 general areas:  1) geography; 2)capital markets; and 3) industry.  The authors also state that while no specific percentage is established as to what constitutes lack of diversification (because breach depends upon the facts and circumstances of each case), the Department of Labor has adopted twenty percent as the threshold concentration in a particular asset for ERISA plans.

 

     See Stephen Torlief Rangen 52 S.E.C. 1304, 1308 (1997) (finding that broker's recommendations were unsuitable, where they resulted in 80% of the equity in customers' accounts being concentrated in one stock - "by concentrating so much of their equity in particular securities, [the broker] increased the risk of loss for these individuals beyond what is consistent with the objective of save, non=speculative investing").

 

7. DUE DILIGENCE – Conducting pre-sale due diligence is the most critical aspect of recommending any security.  Due diligence seeks to protect both the customer and the broker-dealer by ensuring the quality of the security before it is sold.  Due diligence requires sufficient investigation into an investment product to provide "reasonable" grounds to believe that the product is an appropriate investment for the customer. Craig E. Chapman and Katherine Hudson Zrike, Conducting Due Diligence, 278 Practising Law Institute, Corporate Law & Practice Course Handbook, Series B-1304 (2002).  It is an affirmative duty to check and verify the accuracy of certain statements and not rely totally on the unverified words of the issuer or its agent.  In Hanley v. the Securities Exchange Commission,415 F.2d 589, 595-96 (2d Cir. 1969), the Second Circuit Court of Appeals held, "Brokers and salesmen are under a duty to investigate, and their violation of that duty brings them within the term willful in the Exchange Act.  Thus, a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant.  He must analyze sales literature and must not blindly accept recommendations made therein.  The fact that his customers may be sophisticated and knowledgeable does not warrant a less stringent standard."  The Hanly holding was echoed by the recent ninth circuit decision in Securities and Exchange Commission v. GLT Dain Rauscher, Inc. which held that....."a securities professional has the duty to make an investigation that would provide him with a reasonable basis belief that the  key representations in statements made to investors were truthful and complete".

 

     Two years after the GLT Dain Rauscher, Inc. decision, the NASD issued Notice to Members 03-07 which states: "members must perform substantial due diligence in order to satisfy the reasonable requirements for recommendations to investors."  The NASD requirement of a heightened level of due diligence cannot be discharged by relying on the issuer's opinion without verification.  The brokerage firm is obligated to conduct reasonable due diligence into the background of the issuer and manager of a securities offering, the examination of the offering documents, subscription agreements and a review of the performance of the security.  These should be carefully scrutinized to see of they conform to both the sales presentation and the ongoing representations.  Without such investigation, the broker-dealer is merely repeating information disseminated by the issuer/manager to the customer that may be misleading or untrue.  The promise of conducting continuing due diligence by the firm is usually a selling point in recommending any security to the customer.

 

     Even in an unregistered hedge fund, the NASD requires bare minimum due diligence which includes:

 

          a.  "An investigation into the background of the hedge fund manager;

 

          b.  Review of the offering memorandum;

 

          c.  Review of the the subscribing agreements;

 

          d.  Examination of the references; and

 

          e.  Examination of the relative performance of the fund."

 

     In performing due diligence, a broker-dealer wants be sure that the hedge fund is the right (i.e. suitable) hedge fund product for its customer's investment objectives and needs.  Private placements like hedge funds are exempt from registration, not full disclosure!

 

     It is well-settled then, that a securities salesperson : ... cannot recommend a security unless there is an adequate and reasonable basis for such recommendation.  He must disclose facts which he knows and those which are reasonably ascertainable.  By his recommendation, he implies that a reasonable investigation has been made and that his recommendation rests on the conclusions based on such investigation.  Where the salesman lacks essential information about a security, he should disclose this as well as the risks which arise from this lack of information.  Hanley v. SEC, 415 F.2d 589, 597 (2nd Cir. 1969).  Every broker and brokerage firm is under the legal obligation to perform "due diligence" on every trade. This means that the broker must have a reasonable basis founded upon careful investigation before making any recommendation to a customer. This is especially true of proprietary products of the firm the broker represents or products in which the firm makes a market and/or is acting as principal in the transaction. Since there is often increased compensation on these types of products to the broker, the broker must have diligently performed an objective and independent investigation of such products before making recommendations to customers.  That duty, specifically to know your product is set forth in Leib v. Merrill Lynch, Pierce, Fenner & Smith, 461 F. Supp. 951 (E.D. Mich. 1978), aff'd without opinion,647 F,2d 165 (6th Cir. 1981), the court enumerated the duties owed by brokers to customers who maintain non-discretionary accounts:

 

     (1)  the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price and financial prognosis; (2) the duty to carry out the customer's orders promptly in a manner best suited to serve the customer's interests; (3) the duty to inform the customer of the risks involved in purchasing or selling a particular security; (4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security; (5) the duty not to misrepresent any fact material to the transaction; and (6) the duty to transact business only after receiving prior authorization from the customer. Leib, 461 F. Supp. at 953;see also Gochanauer v. A.G. Edwards & Sons, Inc., 810 F. 2d 1042, 1049 (11th Cir. 1987) (endorsing the Leib court's list of duties owed by a broker to a non-discretionary account).

 

       Section 11 of the Securities Act of 1933 underscores this obligation when it states, "no person, other than the issuer, shall be liable...,who shall sustain the burden of proof...that he had, after reasonable investigation, reasonable grounds to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true, and that there was no omission to state a material fact required to be stated therein...."  Every registered representative is obligated then, to fully understand the nature of the investment, its costs, internal features such as deferred sales charges, internal operating costs and/or back end sales loads, historical performance of the investment, terms and conditions of the prospectus, if relevant, appropriate asset classification and any and all other relevant security features.

 

8.  FRAUD - In the securities industry, fraud occurs when a broker recklessly disregards the investment objectives  and risk tolerance of his or her client.  Examples are churning, over-concentration, over-reaching, material omission and material misrepresentation.  These are known as constructive fraud.  The difference between actual fraud and constructive fraud is primarily in the type of conduct which may be treated as fraudulent, such as a failure to disclose material facts within the knowledge of the fiduciary.  Further, the reliance element is relaxed in constructive fraud to the extent we may presume reasonable reliance upon the misrepresentation or nondisclosure of the fiduciary, absent direct evidence of a lack of reliance.  As explained in Estate of Gump (1991) 1 Cal. App. 4th 582,601, "constructive fraud allows conduct insufficient to constitute actual fraud to be treated as such where the parties stand in a fiduciary relationship.  Further, the cause of action for constructive fraud involves overlapping elements of proof.  In general, "constructive fraud arises on a breach of duty by one in a confidential or fiduciary relationship to another which induces justifiable reliance by the latter to his prejudice." Odorizze v. Bloomfield School Dist. (1966) 246 Cal. App.2d 123,129; see also Ford v. Shearson Lehman American Express, Inc. (1986) 180 Cal. App.3d 1011,1020, Civ. Code, #1573).  the theory of constructive fraud "presumes the element of reliance absent substantial evidence to the contrary."  (Edmunds v. Valley Circle Estates 1993) 16 Cal. Appp.4th 1290, 1302; Toedter v. Bradshaw 1958) 164 Cal. App.2d 200, 208).  Civil Code section 1573 states: "Constructive fraud consists: 1. In any breach of duty which, without an actually fraudulent intent, gains an advantage to the person in fault, or anyone claiming under him, by misleading another to his prejudice, or to the prejudice of anyone claiming under him;..."  "[This] section states the rule applicable in confidential relations.... 'Constructive fraud ...is presumed from the relation of the parties to a transaction, or the circumstances under which it takes place.... Constructive fraud often exists where the parties to a contract have a special confidential or fiduciary relationship, which affords the power and means to one to take undue advantage of, or exercise undue influence over the other. "(Mary Pickford Co. v. Bayly Bros., Inc. (1939) 12 Cal.2d 501, 525; and see Boyd v. Bevilacqua (1966) 247 Cal. App.2d 272, 290; Goodwin v. Wolpe (1966) 240 Cal. App.2d 874,878; Crocker-Anglo Nat. Bank v. Kuchman (1964) 224  Cal.App.2d 103,106; Cullen v. Spremo (1956) 142 Cal. App.2d 225,231; Estate of Mallory (1929) 99 Cal.App. 96, 102).  The Sarbanes-Oxley Act of 2002 extended the Statute of Limitations for Securities Fraud by amending Section 1658 of title 28, of the United States Code to read, "A private right of action that involves a claim of fraud, deceit, manipulation, or contrivance in contravention of a regulatory requirement concerning the securities laws, as defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)), may be brought not later than the earlier of "(1) 2 years after the discovery of the facts constituting the violation; or "(2) 5 years after such violation."."  The limitations period provided by section 1658(b) of title 28, United States code, as added by this section, shall apply to all proceedings addressed by this section that are commenced on or after the date of enactment of this Act (July 30, 2002, 107 P.L.204, title VIII, #804, 116 Stat.745).  Both intentional and negligent misrepresentation are actionable in California as fraud.  California Civil Code section 1710 defines fraud as:

 

     1.  The suggestion, as a fact, of that which is not true, by one who does not believe it to be true;

 

     2.  The assertion, as a fact, of that which is not true, by one who has no reasonable ground for believing it to be true;

 

     3.  The suppression of a fact, by one who is bound to disclose it, or who gives information of other facts which are likely to mislead for want of communication of that fact; or,

 

     4.  A promise, made without any intention of performing it.

 

Negligent Misrepresentation requires (1) misrepresentation of past or existing material fact; (2) without reasonable ground for believing it to be true; (3) intent to induce another's reliance on that misrepresentation; (4) ignorance of the truth and justifiable reliance on misrepresentation by party to whom it was directed; and (5) resulting damage.  Glenn K. Jackson, Inc. v. Roe, 273 F.3d 1192,1201 n.2 (9th Cir. 2001).

 

     Under California law, Claimant's/Plaintiff's reliance must be justified.  See Anderson, 56 Cal. App.4th at 1474; see also Alliance Mortgage Co. v. Rothwell, 10 Cal. 4th 1226, 1239 (1995) (holding that justifiable reliance is an essential element of intentional misrepresentation and negligent misrepresentation).  Justifiable reliance is ordinarily a jury question but "may be decided as a matter of law if reasonable minds can come to only one conclusion based on the facts." Id. at 1240.

 

9. SPECIAL SITUATIONS – RISK AND CONTROL.  Some investments are riskier than others and may therefore require additional duties of the broker. For example, trading with money borrowed from the brokerage firm, known as trading on margin, is a carefully regulated activity. There are new regulations requiring full disclosure of the risks in this area.  Brokers also have special responsibilities in connection with options trading, low-priced speculative securities and private placement limited partnerships, along with other unique forms of investments.  Further, the broker, as a fiduciary, has a duty to disclose all material facts of every recommendation, regardless of the sophistication of the investor.  Another special area is in the sale of derivatives.  These are financial contracts whose values are tied to an underlying security, commodity, interest rate or currency.  These speculative investment vehicles have special risks that must be disclosed.  Another special situation occurs with the emphasis and sale of B-share mutual funds to investors.  One cannot overlook all of the heat that regulators and the press are placing on Morgan Stanley Dean Witter for its rampant sales of B-share (back-end load) mutual funds instead of other, often less expensive alternatives.  As reported in the April 1st edition of the Wall Street Journal, the SEC and the NASD are asking why 90% of all mutual funds sold by MSDW are B-shares.  Mutual fund A-shares (front-end load) might have been less expensive, especially with large purchases.  It is often a misconception that brokers in a non-discretionary account owe no fiduciary duty to the investor.  Courts have rejected this theory.  Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 906 F.2d 1206 (8th Cir. 1990) (court rejected defendant's position that non-discretionary accounts can never give rise to a fiduciary relationship, in favor of a more flexible approach focusing on who exercises control over the account). Leib v. Merrill Lynch, Pierce fenner & Smith, Inc., 461 F. Supp. 951  (E.D. Mich. 1978) aff'd. without opinion,  647 F.2d 165 (6th Cir. 1981).  The Lieb opinion states that, "Between the purely non-discretionary account and the purely discretionary account there is a hybrid-type account.  Such an account is one in which the broker has usurped actual control over a technically non-discretionary account.  In such cases the courts have held that the broker owes his customer the same fiduciary duties as he would have had the account been discretionary from the moment of its creation.  Id. at 954.  The Leib court cites Hecht v. Harris, Upham & Co., 430 F.2d 1202 (9th Cir. 1970), and other cases for the long-established rule that fiduciary duties, beyond simply executing trades in accordance with a customer's instructions, exist where a broker has effective control over the customer's account.  In determining whether a broker has assumed control of a non-discretionary account, the courts weigh several factors.  First, the courts examine the age, education, intelligence and investment experience of the customer.  Where the customer is particularly young, Kravitz v. Pressman, Frohlich and Frost, 447 F. Supp. 203 (D.Mass.1978) , old, Hecht v. Harris, supra or naive with regard to financial matters, Marshak v. Blyth Eastman Dillon & Co. Inc., 413 F. Supp. 377 (N.D. Okla. 1975), the courts are likely to find that the broker assumed control over the account.  Second, if the broker is socially or personally involved with the customer, the courts are likely to conclude that the customer relinquished control because of the relationship of trust and confidence.  Kravitz v. Pressman, supra;  Hecht v. Harris, supra.  The Colorado Supreme court has held that a broker may have continuing fiduciary duties with respect to a customer's account despite the fact that it is technically non-discretionary.  In Paine Webber Jackson & Curtis, Inc. v. Adams, 718 P.2d 508,516-17 (Colo. 1986), the court stated, "in assessing the existence of control by a broker, courts have not limited the scope of their vision to the documentation pursuant to which a customer's account is maintained, but instead have examined how account transactions have actually been conducted.  Thus, it has been held that a broker could usurp control over a technically non-discretionary account, rendering that broker subject to the same fiduciary duties as if the account had been discretionary from its creation.  Leib, 461 F. Supp. at 954.  The closely related criterion of a broker's 'involvement` in transactions in a customer's account also has been considered material in resolving the factual question of the existence of a fiduciary duty.  Kaufman, 464 F. Supp. at 536.  If a broker has acted as an investment advisor, and particularly if the customer has almost invariably followed the broker's advice, this in an indication that the broker exercises functional control of the account the that the broker-customer relationship is fiduciary.  See Leboce, 709 F.2d at 607--8; Robinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 337 F. Supp. 107 (N.D. Ala. 1971); Hecht v. Harris, Upham & Co. , 283 F. Supp. 417, 433 (N.D. Cal. 1968), Twomey v. Mitchum, Jones & Templeton, Inc., 262 Cal. App. 2d 690 Cal. Rptr. 222 (1968),  On the other hand, a broker who merely receives and executes a customer's orders does not exercise a degree of control that suggests the recognition of a fiduciary relationship with the customer.  Leboce, 709 F.2d at 607-08; Robinson, 337 F.Supp. 107; Berki, 560 P.2d at 286.

 

     Be careful of placing customers in non-discretionary fee-based accounts when there is little or no trading activity.  You may be charged by the NASD for "reverse churning".  The lack of activity could render the client being better off in a commission based account as a "buy and hold" investor. The NASD is specifically looking for brokers who place a substantial number of their clients in fee based accounts and do little or nothing to advise, monitor and rebalance the accounts.  It is essential to carefully note the file with these accounts to justify the advice you do give.  The NASD has recently issued sanctions against at least two major firms.  Raymond James Financial's employee and independent broker-dealer units were censured and fined $750,000 combined in April 2005 for violations relating to their fee-based accounts.  In addition, the firm had to pay $138,000 in restitution to clients.  In August 2005, Morgan Stanley was fined $1.5 million and ordered to pay more than $4.6 million in restitution for failing to adequately supervise its fee-based brokerage business.

 

10. SUPERVISION AND DUTY OF GOOD FAITH – A brokerage firm has a responsibility to supervise the activities of its brokers. Many customers follow the advice of their broker based upon the reputation of the firm standing behind the broker. It is not sufficient therefore, for a firm to have supervisory methods and guidelines in place to measure overall performance and somehow earn a hypothetical passing grade.  The SEC has stated that the test is whether supervision is reasonably designed to prevent violations in particular cases.  Both the stockbroker and brokerage firm have the responsibility to conduct themselves in good faith with customers. Customers automatically trust and rely upon the broker and the brokerage firms to operate under the high standards imposed upon the securities profession.  In the compliance manual of MSDW, it states, "The Branch Manager must review account information and discuss it with the Financial Advisor.  If necessary, before approving a new account, the Manager must contact the client directly if questions of suitability remain.  The Branch Manager will examine the suitability of transactions and/or investments recommendations based upon the information supplied by the client in the client profile section of the New Account form. The Branch Manager should review and compare the client's stated investment objective(s) with the information that is presented elsewhere on the New Account form and in any supplementary documentation that may be required (e.g. information on the New Account form should coincide with information provided on the client's Option Agreement". The Securities Industry Association ("SIA") Compliance and Legal Division Seminar of 2000 supplied materials on Written Supervisory Procedures which provided that "any supervisor who learns of an indication of impropriety (a "red flag") must investigate with reasonable diligence and must pursue the matter to closure.  Inadequate investigation and follow-up is an invitation to enforcement action."  In Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1573 (9th Cir. 1990) cert. denied, 499 U.S. 976, 111 S. Ct.1621, 113 L. Ed. 2d 719 (1991), the Ninth circuit held that as a matter of law, a broker-dealer is a controlling person with respect to its registered representatives.  The Court reasoned that the securities laws impose on broker-dealers a duty to supervise their registered representatives, and the representatives need the dealers to gain access to the securities markets.  The Court recognized no basis for a distinction between employees or other agents and independent contractors.  PaineWebber, Inc. v. Hofmann, 984 F.2d 1380 (3d Cir. 1993,  the court stated, "Consider Hofmann's claim that PaineWebber sctively concealed Faragalli's wrongdoing.  This can be viewed as an independent cause of action based on a duty owed by PaineWebber to its customers to inform them of a broker's wrongdoing or of the unsuitably speculative nature of their investments".  In 1995, the SEC issued “rogue broker” pronouncements which focused on the necessity for close supervision for certain representatives with regulatory or complaint histories with the need to implement heightened supervisory procedures for these brokers.  Excerpts include:  “In addition to the normal requirements for opening a new account set out in NASD Rule 3110, the manager might choose to speak with all or selected new account holders or to independently verify the customer information on the new account form on a random of consistent basis, depending on the situation.  If the firm deemed it prudent in view of prior activities, it might prohibit any trading until the account information or the order information could be independently verified with the customer.  This logical extension of a broker-dealer’s duty of supervision would have to be adhered to in order to show full compliance”.  “When reviewing conduct to determine whether heightened supervision is warranted, firms should focus on whether a specific type of transaction was involved in prior problems, and should consider prohibiting like transactions, or requiring supervisory approval of all such transactions in advance of execution, as is routinely required in many firms in the case of low-priced securities, options and discretionary trades”.  “Problem brokers should be closely monitored in order to assure that they do not repeat improper sales activities which his or her firm has actual notice of”.  “The firm should consider meeting with the registered rep. and the person who is or will be his or her supervisor, during which the supervisor’s understanding of the prior conduct of the registered rep. and willingness to accept responsibility of his or her supervision can be confirmed”.  “A firm that hires one or more registered representatives with a history of customer complaints, disciplinary actions, or arbitrations, should recognize that it has heightened supervisory responsibilities that will require it, at a minimum, to examine the circumstances at each such case and make a reasonable determination whether it’s standard supervisory and educational programs are adequate to address the issues raised by the record of any such registered rep.”.  (See also NASD Notice to Members #96-60).

 

11.  DUTY TO MAINTAIN CLIENT CONTACT MANAGEMENT - The Branch Manager monitors the registered representatives in the branch to verify each account executive's responsibility to keep client contact management current, organized and complete.  The standard of care in the securities industry requires each representative to record a systematic chronology of client contact in one of the following:

 

     a. Day Timer

 

     b. Acceptable software program such as ACT or Microsoft Outlook

 

     c.  Maintenance of contemporaneous notes in a diary or spiral notebook

 

On a monthly basis, or more often if needed, it is custom and practice in the securities field for a Branch Manager to verify that the registered representatives within the branch are recording, at a minimum:

 

     a.  Differences with clients

 

     b.  Warnings to clients

 

     c.  Client actions which are out of the ordinary i.e. a significantly large number of unsolicited trades

 

     d.  Trade disputes

 

     e.  Client refusal to take the broker's advice.

 

          In its 2000 Branch Office Policy Manual, Merrill Lynch writes, "Documentation and Record Maintenance - While account review records are to maintained electronically, to properly supervise, and demonstrate such supervision, the branch office activity review files must contain:

 

          *  manually prepared P&L of equity change analysis (if applicable),

 

          *  copies of written communications with the client or notations documenting client contacts, and

 

          *  correspondence with the Compliance Department regarding the account

 

these items are to be retained for a period of no less than six (6) years".

 

     As Smith Barney instructs its managers," The most comprehensive and proactive response to client account activity and accounts with material risk exposure is personal client contact by the Branch Manager which is documented in a letter summarizing the contact.  Prior to contacting the client, the Branch Manager should speak with the FC and review the activity and positions in the account.  The Branch Manager should be particularly sensitive to:  -the types of securities traded (e.g. low priced stocks, below investment grade bonds, derivatives, etc.) -Any large positions (i.e. the FC building a position in many accounts) -Margin balance - Volume of trading-Holding periods.

 

12.  DUTY TO PREVENT "FINANCIAL SUICIDE" - In the NASD Rules of Fair Practice - Rule 2310-2 (5) it states that, "recommending the purchase of securities or the continuing purchase of securities in amounts which are inconsistent with the reasonable expectation that the customer has the financial ability to meet such a commitment, exceeds the reasonable grounds of fair dealing".  Further, a brokers responsibility goes beyond mechanical obedience to all customer demands  As the S.E.C. stated in Clyde J. Bruff, 50 S.E.C. 1266, 1269 (1992) [h]aving undertaken to act as an investment counselor for the Pattersons, Bruff was required to make only such recommendations as were in their best interests.  Thus, even if the Pattersons wished to engage in aggressive and speculative options trading, Bruff was obliged to counsel them in a manner consistent with their financial situation.  (citations omitted).  See Charles W. Eye, 50 S.E.C.655, 658 (1991) ("Her request for a plan to increase that income was not a warrant to escalate risks unduly.  If the only approach capable of producing the desired income involved significant dangers, Eye should have advised against it"); Eugene J. Erdos, 47 S.E.C. 985, 988 (1983), aff'd, Erdos v. S.E.C.742 F.2d 507 (9th Cir. 1984) ("Even though Mrs. C. may have desired 'quick profits', that did not entitle Erdos to ignore her individual situation and place her limited assets in risky investments"); and District Business Conduct committee v. Michael R. Euripedes, No. C9B950014, 1997 NASD Discip. LEXIS 45 at *13(NBCC, July 28, 1997) (representative has consultative duty when customers wish to engage in trading that is inconsistent with their financial situation).  In re John M. Reynolds, Rel. No. 34-30036, 1991:  As a fiduciary, a broker is charged with making recommendation in the best interests of his customer even when such recommendations contradict the customer's wishes.  Thus, even if the committee suggested that Reynolds engage in aggressive and speculative trading, Reynolds was obligated to counsel them in a manner consistent with their financial situation. Duffy v. King Cavalier (1989) 215 Cal. App. 3d 1517, defines a stockbroker's fiduciary duty as prohibiting the recommendations of unsuitable securities even if the customer requests the recommendations.  See also Gordon Scott Venters, 51 S.E.C.292,294-5 (1993) (notwithstanding client's interest in investing in speculative securities, broker had duty to refrain from recommending such investments when he learned about his customer's age and financial situation); F.J.Kaufman and Company of Virginia, 50 S.E.C. 164,168 (1989) ("[t]he suitability rule...requires a broker to make a customer-specific determination of suitability and to tailor his recommendations to the customer's financial profile and investment objectives"); and as stated in James B. Chase, 2001 WL 9637888 (NASDR 2001); [The broker] argued that his recommendations of FHC, which he admitted was a speculative stock, were suitable in light of [the customer's] change in her stated investment objectives from "income" to "growth" and "speculation".  A customer's investment objectives, however, are but one factor to consider in determining whether the broker's recommendations were suitable for the customer.  Furthermore, a broker cannot rely upon a customer's investment objectives to justify a series of unsuitable recommendations that may comport with the customer's stated investment objectives but are nonetheless not suitable for the customer, given the customer's financial profile.  Thus, even where a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a broker has a duty to refrain from making recommendations that are incompatible with the customer's financial situation and needs.  See e.g., Paul F. Wickswat, 50 S.E.C. 785, 786-87 (1991) ("The proper inquiry is not whether [the customer'] viewed [the broker's] recommendations as suitable, but whether [the broker] fulfilled his obligation to his client.").  Even in cases in which a customer affirmatively seeks to engage in highly speculative or otherwise aggressive trading, a representative is under a duty to refrain from making recommendations that are incompatible with the customer's financial profile.[FN14]. Danile Richard Howard, Exchange Act Rel. No. 46269 (July 26, 2002), 78 SEC Docket 427,429-30; See also Pinchas, 70 SEC Docket at 1526 (customer's desire to "double her money" does not relieve registered representative of duty to recommend only suitable investments); and William C. Pointek, 81 S.E.C. 2451, 2003 WL 22926821 at *7(2003).

 

     Even though a customer may desire, and even need, more income, a broker may not recommend investing in higher risk investments to meet this customer request.  As the NASD has stated,"(The broker) contented that the [customers[ were willing to accept increased risk for a better yield, but we do not believe that the [customers] understood the nature of the risks involved.  In any event, a customer's desire for income does not warrant an undue escalation of risk.  Similarly, a customer's desire to participate in a booming market by becoming more aggressive must be rejected by the broker and the firm.  The same is true even when the customer who can afford to do so, desires to speculate.  so rigorous is the obligation imposed on brokers and their firms that the SEC has ruled:....assuming that [the customers] did want to invest in speculative securities, that did not affect [the broker's] responsibility t recommend suitable investments.  The test for whether [the broker's] recommendations were suitable is not whether [the customers] acquiesced in them, but whether his recommendations were consistent with their respective financial situations and needs.  Mathew C. Pointek, 81 S.E.C. 2451, 2003 WL 22926821 at *7 (2003) (footnote omitted) (emphasis and parentheticals supplied).

 

     Unfortunately, certain brokers and certain firms do not adhere to the standards imposed upon them by their peers and the regulatory and self-regulatory bodies.  when faced with the failure to adhere to these self-imposed and legally required standards, brokers and firms all to frequently attempt to blame the customer for "agreeing with or approving the strategy, "wanting too much," "being greedy" or  not mentioning the winners." Clinton Hugh Holland, Jr. 60 S.E.C. 25071995 WL 757806 at *3 (1995) ("Even if we conclude that (the customer) understood [the broker's] recommendations and decided to follow them, that does not relieve [the broker] of his obligation to make reasonable recommendations.")(emphasis supplied); William C. Pointek, 81 S.E.C. 2451 WL 22926821 at *7 (2003).  The fact that some of the investments may have been profitable does not change the fact that the recommendations on the whole were unsuitable.  See Clinton Hugh Holland, Jr. 60 S.E.C. 2507, 1995 WL 757806 at n. 17 (1995).  Furthermore, these suitability requirements apply even to unsolicited orders.  As Morgan Stanley informs its brokers:  A financial Adviser should be aware that if a client initiates an order for a transaction that appears unsuitable or is inconsistent with the client's stated objectives, the financial Adviser is    not required to accept that order.  However, in such a situation, the Financial Adviser should advise the client of the basis for believing that the transaction is unsuitable or change the priority of objective codes and record any pertinent facts/conversations in his or her daytimer and obtain a No Solicitation letter as evidence.

 

     Further, prior investment history is not justification for exceeding the client's current risk tolerance, financial situation and need.  FN7 F.J. Kaufman and Company of Virginia, Securities Exchange Act Release no. 27535 (December 13, 1989) 45 SEC Docket 120, 125-126. In our view, [the customer's] prior trades are irrelevant.  A broker must "make a customer-specific determination of suitability and ...tailor his recommendations to the customer's financial profile and investment objectives." [FN7]

 

     As the SEC reminds us:  Determining, however, that the client may have a firm grasp of the market, be "happy" or wish to continue with a high risk trading strategy is not equivalent to an appropriate suitability determination.  A suitability determination is not predicated on what a customer may want.  Rather, NASD Conduct Rule 2310 requires that the determination be made on the basis of the customer's other investments and his financial situation and needs.

 

13.  A BROKER'S CONDUCT IS MEASURED BY THE SECURITIES INDUSTRY RULES - Once the nature and scope of the broker's duties have been determined, it is then necessary to determine whether the broker's conduct constitutes a breach of those duties.  In so doing, it is instructive to review the rules and regulations of the securities industry.  See Miley v. Opptnheimer & Co., Inc. 637 F.2d 318,333 (5th Cir. 1981) ("NYSE and NASD rules are excellent tools against which to assess in part the reasonableness or excessiveness or a broker's handling of an investor's accounts"), citing Mihara v. Dean Witter & Co., Inc. 619 F.2d 814, 824 (C.A. Cal. 1980)("The admission of testimony relating to {NYSE and NASD rules] was proper precisely because the rules reflect the standard to which all brokers are held); see also Jolley v. Welch, 904 F.2d 988,993 (5th cir. 1990)(noting that it was appropriated for the jury to consider NYSE and NASD rules in determining whether the plaintiff's account had been excessively traded); Lange v. H. Hentz & Company, 418 F. Supp. 13776, 1383-84 (N.D. Tex. 1976)("NASD rules are admissible on the issue of what fiduciary duties are owed by a broker to an investor").  What these courts are acknowledging is the propriety of reviewing securities industry rules (also known as "SRO Rules") in determining liability in suitability claims.  The role of the trier-of-fact is to properly determine the applicable standard that determines liability and the brokers obligations typically stem from SRO Rules, Interpretative Materials and Notices to Members.

 

     It is interesting that most brokerage houses agree and promise through a standard clause appearing in all account agreements to obey industry rules and customs (as well as the law) in handling customer accounts:  "All transactions under this agreement shall be in accordance with the rules and customs of the exchange or market and its clearing house, if any, where the transactions are executed and in conformity with applicable law and regulations of governmental authorities and future amendments or supplements thereto"

 

     Respondent's will argue that "any attempt to base a claim on the alleged violation of Rule 405 of the NYSE and other similar industry rules is precluded under the law.  No private right of action exists for violations of industry rules"  This is a disingenuous argument.  The cases cited above state only that industry rules in and of themselves do not create new and independent causes of action.  These authorities do not even remotely suggest that industry rules are in any way irrelevant in an analysis of recognized causes of action such as fiduciary duty, let alone that their use in such an analysis is precluded by law.  It is in fact well-settled that industry rules are highly relevant in determining whether the conduct of a broker is unlawful.  See, e.g. Miley, 637 F.2d at 333 ("NYSE and NASD rules are excellent tools against which to assess in pasrt the reasonableness or excessiveness of a broker's handling of an investor's account")  see also Lange v. H. Hentz & Company, 418 F.Supp. 1376, 1383-84 (N.D. Tex. 1976)("NASD rules are admissible on the issue of what fiduciary duties are owed by a broker to an investor").

 

     There are a number of duties that a broker owes to a customer in servicing a non-discretionary account  One such duty is that of faithfully executing the customer's instructions.  According to the Second Circuit, another duty is that of reasonable care.  Kwiatkowki, 306 F.3d at 1305.  There are also the general fiduciary duties for non-discretionary accounts in California as identified above in that section.  However, states like Texas spell out general fiduciary duties in Texas case law on fiduciary relationships, such as:

 

     (1)  The duty of loyalty and utmost good faith.  See Kinzbach Tool Co. v. Corbett-Wallace corp., 160 S.W. 2d 509, 512 (Tex. 1942); see also Hawthorne v. Guenther, 917 S.W. 2d 924, 934 (Tex. App.-Beaumont 1996, writ denied).

 

     (2)  The duty to act with integrity of the strictest kind.  Hartford Cas. Ins. Co. v. Walker Cty. Agency, 808 S.W.2d 681, 687-88 (Tex. App.- Corpus Christi 1991, no writ).

 

     (3)  The duty of fair and honest dealing.  See Kinsbach Tool, 160 S.W. 2d at 512.

 

     (4)  The duty of candor.  Welder v. Green, 985 S.W. 2d 170, 175 (Tex. App. - Corpus Christi 1998, pet. denied).

 

     (5)  The duty of full disclosure.  See Johnson v. Peckham, 120 S.W. 2d 786,788 (Tex.1938); Welder, 985 S.W.2d at 175.

 

     (6)  The duty to refrain from self-dealing.  Dearing, Inc. v. Spiller, 824 S.W. 2d 728, 733 (Tex. App. - Fort Worth 1992, writ denied).

 

14.  DUTY OF DILIGENCE IN RECRUITING AND HIRING OF REGISTERED REPRESENTATIVES -  Supervising a quality branch in the securities industry begins with hiring practices.  An extensive background check is essential when recruiting existing registered representatives from other member firms.  A best practices review would include the following:

 

     ...A careful examination of an applicant's Forms U-4, U-5 and Central Registration Depository (CRD) files.  These documents disclose previous client complaints, regulatory violations and reasons for terminations;

 

     ...A call to the NASD hotline for further inquiry;

 

     ...A telephone interview with previous supervisors;

 

     ...An outside-the-firm professional background investigation.  The firms that do this work report credit history and inconsistencies in an applicant's U-4.  Additionally, it is important to know about any undisclosed bankruptcy and arrest records.

 

These supervisory methods of best practice firms are easily accomplished and help greatly to prevent abuses.

 

15.  SECURITIES LICENSING AND REGISTRATION - According to the NASD Rules of Fair Practice, individuals who engage in any of the following activities must be registered and securities licensed:

 

     1.  Soliciting orders from customers in securities

 

     2.  Making investment recommendations in securities

 

     3.  Sharing in securities commissions

 

     4.  Soliciting new accounts in securities

 

Securities license and registration are also required if any individual is engaged in any of the following activities:

 

     1.  Sales of securities

 

     2.  Trading in securities

 

     3.  Solicitation of customers for securities

 

     4.  Underwriting of private placements

 

 

 

                       It has long been established hat only duly approved, licensed and registered professionals (who expect either direct or indirect compensation for a particular transaction can give investment advice, that is, to recommend a security to a customer.   And if a non-approved, unlicensed, and unregistered person does give investment advice, and by virtue of that advice is directly or indirectly compensated, he or she can be charged (in most states, it constitutes a third degree or equivalent felony) with "giving investment advice without a license."

 

 

 

 

 

                            SIA BEST PRACTICES, INVESTOR RIGHTS (emphasis supplied)

 

 

 

The Securities Industry Association (SIA) recently set forth 9 industry standard customs and practices to be employed by its 600 member firms:

 

     1.  Inform customers of clear measures of risk for a specific time period;

 

     2.  Provide customers with clearly stated costs and fees (and their effect);

 

     3.  Brokers must know the customer's objectives and risk tolerances;

 

     4.  Provide customers with competent and courteous service and advice;

 

     5.  Provide customers with responsible investment recommendations based on personal objectives, time horizon, risk tolerance, and other factors;

 

     6.  Apprise customers of significant conflicts of interest identified in a financial relationship between an investor and his or her broker-dealer or account representative;

 

     7.  Provide professional assistance to help clarify investment goals and risk tolerance; and

 

     8.  Provide reliable assistance also in setting realistic expectations about the long-term performance and associated risks of various securities; and

 

     9.  Present reasonable investment alternatives designed to meet those expectations, and disclose the comparative risks, benefits and costs.

 

 

 

 

 

 

THE VARIABLE ANNUITY VS. CLASS “B” MUTUAL FUND

 

(A COMPARISON)

 

 

 

 

 

 

 

 

 

 

 

 

 

                                                            FIXED INDEX ANNUITIES

 

                                                         (A Viable Option For Some Seniors)

 

          Fixed Index Annuities (FIA's) are financial instruments in which the issuer, an insurance company, guarantees a stated interest rate and some protection against loss of principal and provides an opportunity to earn additional interest based upon performance of a measured index.

 

          Recently, the Fixed Index Annuity (FIA), a pure insurance product with fully guaranteed and protected principal, has come under close scrutiny from the NASD/FINRA and other regulatory entities.  Insurance annuities are exempted securities under Section 3 (a)(8) of the Securities Act of 1933 when it states, "The provisions of this title shall not apply to the following class:  Any insurance or endowment policy or annuity contract or optional annuity contract issued by a corporation subject to supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any state or territory of the U.S. or District of Columbia".  Rule 151of the '33 Act provides a Safe Harbor:.

 

     a.  Any annuity contract or optional annuity contract (a "contract") shall be deemed to be within the provisions of section 3(a)(8) of the Securities Act of 1933. provided that

 

          1.  The annuity or optional annuity contract is issued by a corporation (the "insurer") subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia;

 

          2.  The insurer assumes the investment risk under the contract as prescribed in paragraph (b) of this rule; and

 

          3.  The contract is not marketed primarily as an investment.

 

     b.  The insurer shall be deemed to assume the investment risk under the contract if:

 

          1.  The value of the contract does not vary according to the investment experience of a separate account;

 

          2.  The insurer for the life of the contract

 

               i.  Guarantees the principal amount of purchase payments and interest credited thereto, less any deduction (without regard to its timing) for sales, administrative or other expenses or charges; and

 

               ii.  Credits a specified rate of interest (as defined in paragraph (c) of this rule) to net purchase payments and interest credited thereto; and

 

          3.  The insurer guarantees that the rate of any interest to be credited in excess of that described in paragraph (b)(2)(ii) will not be modified more frequently than once per year.

 

     c.  The term "specified rate of interest." as used in paragraph (b)(2)(ii) of this rule, means a rate of interest under the contract that is at least equal to the minimum rate required to be credited by the relevant non-forfeiture law in the jurisdiction in which the contract is issued.  If that jurisdiction does not have an applicable non-forfeiture law at the time the contract is issued (or if the minimum rate applicable to an existing contract is no longer mandated in that jurisdiction), the specified rate under the contract must at least be equal to the minimum rate then required for individual annuity contracts by the NAIC Standard Non-forfeiture Law.

 

     See Beverly S. Malone v. Addison Insurance Marketing, Inc. 225 F. Supp. 2d 743,*; 2002 U.S. Dist. LEXIS 18885,**; Fed. Sec. L.Rep. (CCH) P91,990, a case showing that a properly structured Fixed Index Annuity is an insurance product rather than a securities product.  In spite of these facts, in December 2008, the SEC in a 4-1 decision, voted to securitize equity indexed annuities.  This means that in addition to an insurance license, one would need a Series 6 securities license to sell and recommend fixed index annuity products.   However, this ruling has been reversed and currently, as a pure insurance product, only an insurance license is needed to sell the Fixed Index Annuity.

 

     As always, insurance licensed agents must take great care with how these products are sold.  .

 

     It is my opinion that it is the abusive sales practices with FIA's and lesser quality products offered by some inferior insurance companies and not the product itself that has prompted this regulatory action to require dual licensing of agents who sell the product.

 

     While critics make many salient observations about this annuity, they seem to forget that the product is really nothing more than a savings vehicle with a principal guarantee, providing an equity kicker.  They continually focus on the ways its marketed along with the uncompetitive and substandard versions of a basically solid insurance product.  Perhaps a real life story would answer many questions.

 

     In the year 1995, I sold the product to a dear friend's wife who was retiring after many years with a property and casualty insurance company.  I placed the product in her Rollover IRA in the amount of $135,000.  The term of this FIA was 5 years and she was guaranteed the receipt of 3% compounded annually on her fully protected principal or the growth in the S&P 500 index, without dividends, whichever was greater.  In the year 2000, her IRA had grown to over $438,000 net, and we rolled the total amount over on a tax deferred basis (26.U.S. Code SS408) into several annuity companies with  new 5 - 7 year FIA contracts.  Several points are important here.

 

..... The product was appropriate for an IRA only because 100% of the principal was guaranteed by an A+ rated insurance company.

 

..... If the insurance company failed, the value of the annuity (up to $100,000 or more in many states) is guaranteed by the state's insurance guaranty fund.

 

..... 100% of her money went to work in the FIA, since all commissions were paid by the insurance company.  The product also avoided the costs and time delays of probate.

 

..... The commission I earned, payable by the insurance company and not the client, was 5%, an amount that was equal to the surrender period, also 5 years!  Note:  The fact, not the amount of the commission must always be disclosed.  The commission average of all FIA's is 6.37% and lower for older aged seniors.

 

..... The FIA had no management fee, whatsoever, since the potential growth was measured against a published index, requiring no management time or expense.  Penalty free withdrawals of 10% annually were permitted after year one.

 

Additional benefits with the multi-company laddered approach include:

 

.....The growth in the FIA accumulates on a tax deferred basis, outside of an IRA.  Between 1997 and 2007 FIA's averaged an annualized return of 5.79%, nationally.  For the same period, the 5 year C.D. rate was 2.23%

 

.....The FIA's had a declining surrender charge beginning at 5 - 7% and declining each year.  After the first year, 10% withdrawals were free and not subject to this penalty.  This feature should be appropriate for any person willing to hold the annuity for 5 - 7 years, similar to growth positions like mutual funds.  While less attractive contracts have beginning surrender charges of up to 20%, the average first yr. surrender percentage for all contracts is 10.77% and only 9.69% for elderly purchasers.

 

.....Several insurance carriers were utilized to ladder the vehicles, spread the risk and add flexibility and diversification to the portfolio.

 

.....You were able to annuitize the FIA contracts after one year and eliminate all surrender charges whatsoever.  Be careful of companies that require a 5 year wait to annuitize or reduce the amount by the bonus received up front.  Quality companies also offer a guaranteed withdrawal (income) benefit that assures the return of original principal, less withdrawals.

 

.....There were living benefit riders including terminal illness and nursing home care built into each contract without additional cost.  Better contracts include surrender free withdrawals for disability and unemployment as well.

 

From the year 2000 on, she kept her principal safe during the worst market downturn since the depression!

 

     Critics that lambaste this product refer to the complexity of the vehicle due to its "moving parts" as known in the trade.  Many of these complexities are abusive and typically come from lower tier insurance companies trying to compete with quality companies in the marketplace.  Examples are bonuses, low caps, spreads and high asset fees.  Most of the larger quality companies simplify or eliminate the need for most of these.

 

     Lets deal with the major concerns of FIA critics in order:

 

"These annuities aren't risk free growth opportunities".  I beg to disagree.  They really are equivalent to that with the principal fully guaranteed (minus withdrawals) as a living benefit, plus 1.5% compounded annually.  Visualize two stacks of money.  One is your principal plus 1.5% compounded annually.  The total of that stack after 5 to 7 years is compared to the other stack.  That second one increases only by the the growth component of approximately 740 of the S&P 500 index, without dividends, for that same 5 to 7 years.  If the index declines,  the account stays level, without decreasing, whatsoever.  Each year, the growth potential starts over, measured from a new basis.  At the end of the term, the two stacks are compared and the customer receives the larger stack.  This of course assumes the customer is willing to stay in the annuity (10% emergency withdrawals are permitted) until the 1.5% guarantee on principal is greater than the the surrender charge.  However, this could  be a shorter time period if the market experiences gains.  To put it another way, the client has the upside potential of approximately 40% of the stock market growth with their downside totally protected, with guaranteed principal plus 1.5% compounded annually.  To me, unquestionably, that's equivalent to a risk free growth opportunity.  The current guarantee average in 2014 is 1.45%.

 

The next concern is "The stock market returns are as flimsy as a Hollywood stage set.  This is because of limited participation rates and the elimination of the index's dividends".  Lets consider these two in reverse order.  The suggestion usually is that the dividends your giving up are usually in the 4% range!  Let's look at recent history as provided by Standard and Poors.  The dividends between 2000 and 2007 were as follows:

 

     2000 - 1.16%            2004 - 1.64%          2008 - 2010 - 1.00 - 1.50%

 

     2001 - 1.38%            2005 - 1.75%          2011 - 2014 -   .75 - 1.25%

 

     2002 - 1.69%            2006 - 1.79%

 

     2003 - 1.70%            2007 - 1.80%

 

     These percentages for dividends actually indicate an average of just 1.40 % over the last 10 years, only about 35% of the suggested 4% average that the participant is giving up.  And by the way, savers that want risk free growth of their principal, are not looking for returns of 1.4% at all.  They're hoping for real returns without risk!

 

     Further, when you think about, if insurance carriers were to include dividends, there would be a corresponding cost to do so.  That increased cost would result in lower crediting factors (i.e. caps, spreads, participation rates and fees).  Then, of course the index return would be slightly higher, but with a lower crediting factor.  Paying dividends would also make the product more complex.  Would the dividends be reinvested?  Would they simply be added to the return?  And even if the extra complication is minimal, why include it when there is no meaningful financial benefit to the customer.  Remember, there is no such thing as a free lunch.

 

     With respect to the second area, returns are, in fact. limited by participation rates, only one of those "moving parts".  This was done to guard against the unusual windfall of 25% average market growth rate in the mid-90's which would be difficult for any guaranteed vehicle to pay out to savers.  However, a number of quality company's offer up to 40% participation rate in the S&P 500 index, absent the dividends, without bonuses, caps,  spreads, asset fees or other non-competitive limitations.  And remember, there is no reduction in a down-market year.  That's a very important factor along with the elimination of principal risk.  As an alternative, other quality companies offer a "spread" or annual fee of .95% (just under 1%) to 200 basis points, currently (2%).with a 100% participation rate.  The effect of these uncapped fixed index annuities (Allianz and Nationwide) are that instead of a return of 5 - 6% in the "capped" ones, the "spread" index annuities, without caps, should return about 9 - 10% net to the investor, much more competitive.

 

     Another criticism is "The percentage savings guarantee is only paid on 87.5% or 90% of your principal".  Again, this is true with some lower tier companies, but not with the quality insurers.  There are in fact a good number of companies that guarantee the full percentage compounded on the full original principal!  And that full savings percentage is competitive with most bank savings rates in today's economy.  The quality insurers will of course adjust  the guaranteed return as interest rates rise or fall.  Currently, due to low interest rates, that guaranteed floor has declined to a little above 1% with many companies from as high as 2% to 3% of the total premium several years ago.

 

     Another bombardment is "Agents are rewarded with commissions in the 10% to 15% range".  Remember the formula.  Commissions are closely related to the number of years in the surrender period.  Yes, its true that some FIA's, issued by the more aggressive, lower tier companies, extend surrender periods out to 12-15 years and advance the accompanying 10% to 13% commission directly to the agents.  While those products do exist, they are clearly not appropriate for everyone.  In fact, some of the good companies offer both long and short surrenders with commissions adapted to the varying ages of the annuity holders.  I have personally been selling FIA's since 1995 and have never sold one with a surrender period beyond 9 years.  Even then, that 9 year surrender period was to younger clients, who, due to their age, would be holding the annuity for more than 10 years, with its built-in flexibility.  For older clients, there are quality products that have only 3,5 and 7 year declining surrender periods which are much more appropriate.  These of course carry only a 2% - 6% commission.  I would be wary of selling a 12-15 year product mainly because of the fact that they should never extend beyond the seniors life expectancy and because there are plenty of good ones that have far shorter and more appropriate surrender periods and commissions.  And remember this!  Consider that a fund manager or investment advisor could charge 2 percent each year in fees on an investment account.  Over a 10-year period, that equates to an approximate 20% cost to the customer.  On the other hand, an average 10-year fixed-index annuity has an 8% commission.  That commission is to compensate the producer for servicing the client over the next 10 years.  Furthermore, this commission is paid by the insurance company - not the customer.

 

     Finally, it is contended that "If another agent analyzes your FIA, he or she would probably want to earn another commission by rolling you into a new and "better" FIA.  First of all, a reputable agent would wait to do a 1035 exchange until the surrender period was over!  Even first year bonuses on the new contract used to offset the old FIA's surrender charge can and should be avoided.  That bonus has a cost and is usually going to be in the form or a lengthening of the surrender period or higher surrender charges or both.  That's just another moving part and the quality companies that do not have to overreach for business, typically don't offer them.  One insurance carrier, Allianz offered a 10% upfront bonus product called the MasterDex 10.  However, it was a two-tiered equity index annuity and required annuitization,  meaning the policyholder could take the premium bonus and any indexed gains only if the product were annuitized for a stated term after a specific deferral period.  The 65 year old retiree went to court and a jury ruled that Allianz had used a misrepresentation or deceptive sales practice in selling its two-tiered annuities and that it had intended that others would rely on its misrepresentation or deceptive practice, according to the verdict.  While bonuses should be avoided in most cases, there are always exceptions.  In some cases, the bonus can be used effectively as a jump start for those who lost money due to market declines.

 

     When I rolled my friend's wife into that second annuity, I only did so after the original policy had matured and the new one had hardly any of those "moving parts" and only a 7 year declining surrender period.  And of  course, the contract offered, without any penalty, the minimal withdrawal of $43,000 per year (10% of the accumulated value).

 

    Critics invariably complain about the complexity of FIA products.  However, the average fixed index annuity contract contains 26.7 pages versus 200 pages for a variable annuity prospectus.

 

     The key to the FIA issued by quality companies is flexibility.  Each year on the policy anniversary, the insured can select a different mix or combination of indexes or choices to measure the growth of the product.  This is critically important during times the stock market is cycling downward, sideways or in a highly volatile fashion.  Alternatives to tracking the S&P 500, include the Dow Jones Industrial Average, the Russell 2000 Small Cap Index, the NASDAQ, the Barclay's Aggregate Bond Index or even a fixed rate declared each year by the Board of Directors of the insurance company.  The individual on an annual basis can allocate percentages of the FIA between the various options offered.  If the product is carefully tailored to the age and needs of the insured, the equity indexed annuity has significant advantages.

 

     For example, there is typically a no-cost nursing home/terminal illness plus disability/unemployment rider that comes automatically with the quality company policies.  The surrender charge is fully waived if a life threatening illness occurs or waived by between 25 - 50% after a 60 day confinement in a qualified nursing home or assisted living facility, depending upon the insurance company offering the FIA.  Some companies offer these benefits to seniors, up to age 85.

 

     Two very competitive policies currently available are from Forthright Life (A-) which offers a 3 year product with a 20% cap and Athene Life (Fmly. Aviva) (A) offering a 6 year product which combines a growth account (50%), measured against the S&P 500, without a cap with a fixed account (50%) with up to a 1.5% fixed return.

 

     Along with great flexibility in the living benefits, there are important advantages to the guaranteed death benefit.  Critics argue that this feature is overrated and has little value.  They couldn't be more wrong.  Consider someone who has retired or been fired from his employment with only nominal group insurance which is neither portable nor sufficient in size.  How about someone who is uninsurable or is rated for health reasons, making typical cost life insurance unaffordable.  Here the death benefit, without additional cost, is guaranteed to be no less than the original amount invested, less any withdrawals.  If the market increases, the death benefit increases to the greater of original cost or accumulated market value.  Again, quality companies automatically "step-up" the death benefit at periodic intervals as stated in the contracts.

 

     As beneficial as this vehicle sounds, one should avoid placing more than 15% - 20% of their tangible net worth in the fixed index annuity.  For further diversification, more than one annuity should be considered in a laddered approach (with declining surrender periods) for added flexibility and spreading the risk of insurance carriers.  Finally, since the vehicle is principle guaranteed, it would be appropriate for an IRA even though the tax deferral benefits are wasted.  Look though for a compelling need of the guaranteed death benefit and health riders to justify an IRA investment with the FIA.   Properly used, it can be a life saver for suitable individuals as a "safe money place" or retirement savings vehicle.

 

     NASD Notice to Members 05-50 issued in August 2005 states that member firms treat the sale of unregistered FIA's (those not registered as securities under the Securities Act) by associated persons in their capacity as insurance agents as on outside business activity under NASD/FINRA Rule 3030, beyond the firm's mandated purview of the firm's supervision.  Rule 3030 does not require that the firm supervise or even approve an outside business activity, although a firm may choose to deny or limit the ability of associated persons to engage in this solely insurance activity.  After August 2005, member firms must adopt special procedures under Rule 3030 with respect to these FIA products.  In particular, firms must require that their associated persons promptly notify the firm in writing when they intend to sell FIA's.  Moreover, all recommendations to liquidate or surrender a registered security such as a mutual fund, variable annuity, or variable life contract must be suitable, including where such liquidations or surrender are for the purpose of funding the purchase of an insurance FIA.  Further, the NASD/FINRA encourages forms to consider whether other supervisory procedures also might help protect the firm's customers.  For example, a firm could require that all sales of unregistered FIA's occur through the firm.  If an associated person is selling the FIA through the firm, the firm must supervise the marketing material, suitability analysis, and other sales practices associated with the recommendation of unregistered FIA's in the same manner that is supervises the sale of securities.

 

     In the year 2005, the National Association of Insurance Commissioners promulgated model suitability in annuities regulations which for the first time placed "suitability" at the forefront of the sale of insurance only products.  Prior to that time, only the sale of securities bore the requirement of suitability obligations to the investor.  The intent of these insurance regulations were directed at the increasing sales to the senior marketplace.  To that end, the Insurance Marketplace Standards Association (IMSA) opted to make a positive, proactive step by creating a new suitability clearinghouse program.  Beginning in 2007, the clearinghouse offered IMSA members the opportunity to carefully vet their offerings with an eye to the model regulations established by NAIC.  Many insurance carriers have strengthened their internal compliance procedures with one notably creating the new post of Chief Suitability Officer.  A questionnaire like this one is close to getting the kind of answers that meet senior suitability obligations:

 

     In order to address your concerns with greater accuracy, prior to your annuity purchase, we would appreciate your response to the following  questions.

 

     1.  Please provide your age. _______

 

     2.  Is the sum of money you are considering qualified or non-qualified?

 

          A)  qualified ___ (pre-taxed savings or investments inside an IRA, 401-k, TSA, 403-B, 501-c)

 

          B)  non-qualified ___ (after-tax savings or investments currently in CD's, mutual funds, fixed-annuities,

 

     3.  In regard to the sum of money you are considering, what percentage of your liquid assets does this amount

 

          represent?  10%__20%__30%__40%__50%__60%__70%__80%__90%__100%

 

     4.  Are you in reasonable good health? Yes__ No__ (Provide additional information if you answered no)

 

     5.  In regard to your risk tolerance financially, which of the following describes your attitude best?

 

          Conservative__ "I cannot tolerate any loss of my principal."

 

          Moderate/Conservative__ "I cannot tolerate any loss of my principal, however, I am willing to accept a

 

              zero percent return in a particular year (when a market index is down for the year), in exchange for

 

              moderate returns (when a market index is up in other years), as long as my principal and interest gains

 

              are locked in my account annually."

 

          Moderate__ "I can accept moderate short-term losses in exchange for the possibility of moderate long-term

 

               gains."

 

          Aggressive__ "I can tolerate large losses in exchange for the possibility of long-term gains."

 

          6. Which is important to you?

 

               A)  Increasing account values conservatively (with no stock market risk) __

 

               B)  Increasing account values moderately (with no stock market risk) __

 

               C)  Increasing account values moderately (with stock market risk) __

 

               D)  Increasing account values substantially (with stock market risk) __

 

 

 

          7.  Which is of greater concern; making money in the stock market or not losing money?

 

                 A)  Making money __

 

                 B)  Not losing money __

 

          8.  Can you tolerate losing any of your money in the stock market?

 

                 A)   Yes __ No __

 

          9.  If the answer is yes, what percentage can you tolerate losing?

 

                 10% __ 20% __ 30% __ 40% __ 50% __

 

         10.  Have you ever invested in the following types of securities?

 

                  Stocks__

 

                  Bonds __

 

                  Mutual Funds __

 

                  Variable Annuities __

 

           11.  Have you ever placed money in any of the following?

 

                   U.S. Treasuries __

 

                   Certificates of Deposit (CD's) __

 

                   Fixed Annuities __

 

                   Fixed-Indexed Annuities __

 

                   Income Annuities __

 

            12.  Are your monies intended to provide income years from now (your time horizon)?

 

                    1 year __

 

                    Between 1 - 4 years __

 

                    5 years __

 

                    Between 6 - 9 years __

 

                    10 years__

 

                    Greater than 10 years from now __

 

              13.  If your monies is qualified (pre-tax, IRA for example), is this particular sum of money intended to be

 

                          passed on to beneficiaries (heirs)?

 

                     Yes __ No __ (Please provide additional information if you  think it is warranted.)

 

               14.  Do you currently have a life insurance policy?

 

                      Yes __ No__ (Please state amount and purpose)______________________________________

 

                       ____________________________________________________________________________

 

 

 

               Name _____________________________________ (Please Print)

 

               Client Signature ____________________________________

 

               Date _________________

 

               Thank you

 

 

 

      The SEC proposed Rule 151A, securitizing fixed index annuities in an attempt to better protect investors, especially senior investors, against the abuses associated with the marketing and sale of fixed index annuities.  Sales of FIA's have grown dramatically in recent years, with $25 billion sold in 2007, for a total outstanding value of $123 billion of equity indexed annuities held by investors.

 

     The SEC was concerned because complaints associated with equity indexed annuities have risen dramatically.  Commentators quip that the products are "sold, not bought" to imply that high pressure sales tactics often are involved.  State securities regulators have identified the products "as among the most pervasive products involved in senior investment fraud."  Likewise, the 2005 notice to members issued by the NASD (Now FINRA) cited concerns "about the manner in which persons associated with broker-dealers were marketing unregistered indexed annuities and the absence of adequate supervision of those sales practices."  Additionally, that notice "expressed NASD's concern with FIA sales materials that do not fully describe the features and risks of the products."  Finally, a joint examination conducted in 2007 by all three regulators - the SEC,, FINRA and state regulators - "identified potentially misleading sales materials and potential suitability issues" related to investment products, commonly including indexed annuities, at so called "free lunch" seminars.  Accordingly, working with state regulators, the SEC has made "cracking down on fraud in this area a top priority", and the "recent December rulemaking is a big part of that effort."

 

     Lets examine why the SEC proposed the new licensing requirement.  As background, the challenge for the SEC had been to make a convincing argument that this kind of annuity is less of an insurance product and more of a securities product, such that it should be regulated as a security.  Why the challenge?  Section 3(a)(8) of the Securities act provides an exemption under the Securities Act for certain insurance contracts.  Additionally, the U.S. Supreme Court has weighed in on what constitutes insurance, to be regulated by state insurance commissioners, and what constitutes securities, to be regulated by the SEC.  According to the U.S. Supreme Court, Congress intended to include in the insurance exemption only those policies and contracts that include a "true underwriting of risks" and "investment risk-taking" by the insurer (and not the insured, the purchaser).  Moreover, the assumption of an investment risk does not, "by itself create an insurance provision under the federal definition"; in other words, the level of risk assumption by the insurer must be meaningful and substantial.

 

     With that Supreme Court guidance in mind, the SEC in its analysis stated:  Individuals who purchase fixed index annuities are exposed to a significant investment risk - i.e., the volatility of the underlying securities index.... Indexed annuities are attractive to purchasers because they promise to offer market-related gains.  Thus, these purchasers obtain FIA contracts for many of the same reasons that individuals purchase mutual funds and variable annuities [both of which are securities], and open brokerage accounts.

 

     The SEC also needed to address, and it did address, a feature of the fixed index annuity which removes some risk from the product; a guaranteed certain minimum value to the purchaser.  The SEC states that although the insurance company guarantees this certain minimum value, that value typically is less than 90% of the money contributed.  As a result, the SEC concluded:  Such indexed annuity contracts provide some protection against the risk of loss, but these provisions do not, "by [themselves,] create an insurance provision under the federal definition".  Rather, these provisions reduce - but do not eliminate - a purchaser's exposure to investment risk under the contract.  These contracts may to some degree be insured, but that degree may be too small to make the indexed-annuity a contract of insurance.

 

     Accordingly, the SEC established a new definition of "annuity contract" that would define a class of fixed index annuities that are outside the scope of Section 3(a)(8) of the Securities Act.  The SEC's new rule provided that an indexed annuity was not an "annuity contract" under this insurance exemption if the amounts payable by the insurer under the contract were more likely than not to exceed the amounts guaranteed under the contract.  The rule established standards for determining when equity-indexed annuities were not considered annuity contracts under the securities laws and thus subject to the investor protections against fraud and misrepresentation, which limit the potential for sales practice abuses in marketing fixed index annuities to older investors.  The SEC's new rule defined the terms "annuity contract" and "optional annuity contract" under the Securities Act of 1933.  The rule clarified the status under the federal securities laws of equity-indexed annuities, under which payments to the purchaser were dependent on the performance of a securities index.  The new definition only applied to fixed index annuities issued on or after January 12, 2013.

 

In July, 2009, a federal appeals court ordered the SEC to reconsider the rule that classified indexed annuities as securities and subjected them to federal oversight.  The U.S. Court of Appeals for the District of Columbia Circuit said the SEC needed to do a more thorough review of the existing state-law regime that has governed fixed index annuities.  A coalition of insurers and marketing groups argued that FIA's are insurance products, and therefore should be regulated strictly by the states.

 

     Important for the SEC, the appeals court said it was reasonable for the SEC to conclude that fixed index annuities were different from traditional fixed annuities - and not exempt from federal regulation.  The case is American Equity Investment Life Insurance Co. v. SEC, 09-1021.  In effect, this court case answered two questions:

 

     1.  Did the SEC act reasonably when it determined that fixed index annuities ("FIA's") are not "annuity contracts" and are therefore securities under the 1933 Security Act's definition?  Answer - Yes.

 

     2.  Did the SEC fulfill its statutory obligation to consider the effect of the new rule on efficiency, competition and capital formation, prior to passing the rule?  Answer - No.

 

     In July, 2010. a Federal Appeals Court (D.C. Circuit Court of Appeals) has ruled and now classifies fixed index annuities as insurance products rather than securities.  The 3 judge panel indicated that the SEC "failed to properly consider the effect of the rule upon efficiency, competition and capital formation".  The court vacated Rule 151A and it will now be up to the State Insurance Administrators to deal with these fixed indexed annuities as insurance rather than securities products.  Further, Senator Tom Harkin, D-Iowa, recently persuaded a congressional conference committee to add a provision to H.R. 4173. the financial services bill, that would classify indexed annuities governed by standards developed by the National Association of Insurance Commissioners (NAIC), Kansas City, MO., as state-regulated insurance products.  The court order maintains the status quo.

 

    Sales of fixed indexed annuities were estimated by LIMRA to hit $33 billion by year-end 2010, up from $29 billion in 2009.  Forty-one percent of fixed annuities sold in 2010 were tax-deferred annuities linked to the market (FIA's).  And 91% of all fixed indexed annuities were sold by independent broker-dealers, according to Beacon Research, Evanston, Ill.

 

     In the 5 years that included the technology crash meltdown from 1998 to 2003, the average fixed index annuity grew at a 5.5% annual rate.  By contrast, the S&P 500 registered an annual negative return of        -0.4%.  In the up market from 2002 to 2007, the S&P 500 grew at an annual rate of 13.37%.  Meanwhile, FIA's grew at a 6.12% annual rate.

 

     Over the past 5 years ending in November 2010, the average fixed index annuity credited a 3.9% annualized interest rate.  By contrast, one-year CD's yielded 2.8% annually and five-year CD's yielded 3.8% (taxable), reports Advantage Compendium in St. Louis.  by contrast, the S&P 500 index grew at just a 0.65% annual rate over the same period (11/2005 - 11/2010).

 

     In terms of choosing a crediting method in the FIA, I would recommend against choosing the "term-point-to-point" method of crediting interest.  Point-to-point compares the change in the index at two discrete points in time, such as the beginning and ending dates of the contract term.   If the index declines dramatically on the last day of the term, part or all of the earlier gains can be lost.  Surrendering early also can wipe out gains.  The most judicious crediting method is the point-to-point with a monthly or annual reset.  The annual reset compared the change in the index from the beginning of the month to the end of the month or the beginning of the year to the end of the year.  Thus, your gain is always locked in.  This method works best in volatile or uncertain markets.

 

     FIA's may also average an index's value either daily or monthly rather than using the actual value of the index on a specified date.  Averaging may reduce the amount of index-linked interest you earn.

 

     The High Water Mark is another crediting option.  It considers the index value at various points during the contract, usually annual anniversaries.  It then takes the highest of these values and compares it to the index level at the start of the term.  The advantage here is that this method may credit you with more interest than the other indexing methods and protect against declines in the index.  The disadvantage, however is that because interest is not credited until the end of the term, you may not receive any index-linked gain if you surrender your index annuity early.   For less volatile markets and for staying the course this method should strongly be considered.

 

     In the final analysis, you can and should avoid the policy limitations structured into the policies of lower tier insurance carriers.  I felt compelled to write this piece in support of a much needed alternative product for savers, when structured and marketed properly.  Many securities salespeople do not sell or have even heard of this product since it has always been a pure insurance vehicle, requiring an insurance license only, to sell it.  I am proud to have good quality, principal protected  FIA's as an additional arrow in my quiver to offer to my client base as an alternative to stock market uncertainty and volatility.

 

__________________________________________________________________________________________

 

Mason Alan Dinehart III, RFC is a CA Licensed Insurance Agent (0643601), Registered Securities Principal, Due Diligence and  Director of Advertising Compliance with Silber Bennett Financial, Inc., and is also  a Securities Industry Expert Witness and Member, FINRA Board of Arbitrators (A30388).