Chapter 6 — Disclosure & Agent Responsibilities (continued)

FINRA, the Financial Industry Regulatory Authority, is the largest non-governmental regulator of securities firms doing business in the United States. Created in 2007 through the consolidation of NASD’s and NYSE’s member regulation and arbitration functions, FINRA protects investors and securities market integrity. It does so by registering and educating all industry participants; auditing securities firms; writing and enforcing industry rules and federal securities laws; informing and educating the investing public; providing trade reports; and resolving disputes between investors and registered firms.

FINRA’s rules apply specifically to variable annuity recommendations and sales by registered representatives of FINRA member broker-dealers. Fixed and fixed indexed annuities are not securities and are not governed by FINRA, though broker-dealers who sell those products must still comply with Florida’s Best Interest standard under F.S. §627.4554.

FINRA’s general suitability obligation has been updated twice since this course was originally written. The original NASD Rule 2310 was replaced by FINRA Rule 2111 (Suitability), which took effect July 9, 2012. Rule 2111 required members to have a reasonable basis for believing a recommended strategy was suitable for the customer. It established three components of the suitability obligation:

• Reasonable-basis suitability — The member must have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.
• Customer-specific suitability — Based on a particular customer’s investment profile, the member must have a reasonable basis to believe the recommendation is suitable for that customer.
• Quantitative suitability — A member with de facto control over a customer’s account must have a reasonable basis for believing a series of recommended transactions is not excessive and unsuitable, even if each transaction individually may be suitable.

SEC Regulation Best Interest (Reg BI) — Effective June 30, 2020

For recommendations to retail customers, FINRA Rule 2111’s suitability obligation was effectively superseded by the SEC’s Regulation Best Interest (Reg BI), which took effect June 30, 2020. Reg BI establishes a best interest standard — higher than the prior suitability standard — for broker-dealer recommendations to retail customers. Under Reg BI, a broker-dealer must act in the best interest of the retail customer at the time of the recommendation, without placing the financial or other interest of the broker-dealer ahead of the customer’s interest.

Reg BI requires broker-dealers to satisfy four component obligations:

• Disclosure Obligation — Disclose key information about the recommendation and the relationship, including conflicts of interest.
• Care Obligation — Exercise reasonable diligence, care, and skill to understand the product and have a reasonable basis to believe the recommendation is in the customer’s best interest based on the customer’s investment profile and reasonably available alternatives.
• Conflict of Interest Obligation — Establish, maintain, and enforce written policies and procedures reasonably designed to identify and address conflicts of interest.
• Compliance Obligation — Establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Reg BI.

The original Rule 2821 governing deferred variable annuity sales has been renumbered as FINRA Rule 2330 (Members’ Responsibilities Regarding Deferred Variable Annuities). The rule was designed to enhance broker-dealers’ compliance and supervisory systems and provide more comprehensive and targeted protection to investors who purchase or exchange deferred variable annuities. Deferred variable annuities are complex investments containing both securities and insurance features, which can be confusing for both the agents who sell them and the customers who buy them.

Rule 2330 has four main requirements:

1. Registered Representative Recommendations

When recommending a deferred variable annuity transaction, a registered representative must:

• Make a reasonable effort to obtain and consider various types of customer-specific information, including age, income, financial situation and needs, investment experience and objectives, intended use of the deferred variable annuity, investment time horizon, existing assets, liquidity needs, liquid net worth, risk tolerance, and tax status
• Have a reasonable basis to believe the customer has been informed of the material features of a deferred variable annuity, such as surrender charges, potential tax penalties, various fees and costs, and market risk (note: delivery of disclosure documents alone is not sufficient — the agent must make a reasonable effort to educate the customer on these features)
• Have a reasonable basis to believe the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization, or death or living benefits (the customer need not benefit from every feature, but some contract features must genuinely be of value to that particular client)
• Make a customer suitability determination as to the investment in the deferred variable annuity, the investments in the underlying subaccounts at the time of purchase or exchange, and all riders and other product enhancements and features in the annuity contract
• Have a reasonable basis to believe that a deferred annuity exchange is suitable for the particular customer, considering among other factors whether the customer would: incur a surrender charge; be subject to a new surrender period; lose existing benefits; be subject to increased fees or charges; and whether the customer has had another exchange within the preceding 36 months

2. Principal Review and Approval

Rule 2330 requires a registered principal (a supervisor such as a branch office manager) to review and determine whether to approve a customer’s application for a deferred variable annuity before transmitting it to the issuing insurance company. The rule calls for principal approval within seven business days after the customer signs the application.

The principal must treat all transactions as if they have been recommended for purposes of review. The principal can approve the transaction only if it is suitable based on all applicable factors. However, the principal may authorize processing of the transaction even without suitability approval in two specific circumstances: (1) the transaction was not recommended by the representative, and (2) the customer, after being told why the principal found it to be unsuitable, still wants to proceed with the purchase or exchange.

3. Firm Supervisory Procedures

Broker-dealers must establish and maintain written supervisory procedures reasonably designed to achieve compliance with Rule 2330’s standards. One specific requirement is that broker-dealers implement surveillance procedures to determine whether any registered representatives have a pattern of exchanging (replacing) variable annuity contracts that might evidence misconduct. Each firm must have policies and procedures in place to address inappropriate exchanges — consistent with the 36-month lookback requirement in the rule.

4. Firm Training Programs

Rule 2330 requires firms to create training programs for registered representatives who sell deferred variable annuities and for registered principals who review deferred variable annuity transactions. Training must cover the suitability factors, the principal review process, and the firm’s written supervisory procedures. FINRA provides training resources for registered representatives and principals through its website at finra.org.

As part of the Reg BI package, the SEC also requires broker-dealers and investment advisers to provide retail investors with a short-form disclosure document called Form CRS (Customer or Client Relationship Summary). Form CRS must be delivered to new retail customers at or before the earliest of:

• Entering into an investment advisory agreement
• The first recommendation of a securities transaction or investment strategy
• The placing of an order for the retail investor

Form CRS discloses in plain language: the types of services offered; the fees, costs, conflicts of interest, and required standard of conduct associated with those services; whether the firm and its financial professionals have disciplinary history relevant to retail investors; and how to get more information.