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Recent NASD Enforcement and Examination Priorities


A review of recent NASD actions and notices to members suggests that older issues remain a priority for examiners, but some new topics are now raising regulatory eyebrows. The lesson learned from prior actions against member firms is that NASD is resolved to take a strong position on a regulatory issue, even on issues not immediately evident to the industry.

Share Sales Practices

NASD's scrutiny of mutual fund share sales practices has not abated and, as with prior years, mutual funds continue to be a priority. In 2005 alone, NASD's Class B and Class C share enforcement actions resulted in an exchange or refund offer to 79,000 households. NASD has continuously reminded member firms of the need "to conduct an analysis of the effects of the fee structure on an investor's return and to recommend the share class that is most advantageous for the customer" and to evaluate their control systems to ensure compliance with this directive.

NASD's recent actions against several major member firms underscore the regulator's continued concerns. For instance, in December 2005, NASD announced that it had fined several member firms $19.4 million for share-class violations. NASD found that the firms had liability based upon sales to customers who would have benefited from sales of Class A shares in terms of higher overall rate of return.

Directed-Brokerage Violations

In April 2006, NASD announced that it had fined a member more than $1.1 million for receipt of directed brokerage in return for providing preferential treatment to certain mutual fund companies. NASD noted that participation in such "preferred partner" or "shelf space" programs gives certain mutual fund companies a competitive advantage and preference inside the firm against other fund companies in spite of a customer's needs. This most recent case, as with prior actions, involved violations of NASD's Anti-Reciprocal Rule, which "is designed to ensure that firms recommend mutual funds on their merits and not because of the receipt of brokerage commissions, which are assets of the mutual fund shareholders and should not be used for marketing purposes."

To date, NASD has brought 30 actions based on these types of violations. Expect case number 31 to follow soon.

Variable Insurance Products

Because of the complexity of variable insurance products and a series of recent sales practice violations, NASD has continued its efforts to scrutinize sales procedures and supervision of variable insurance products by members. NASD has said that its "examiners will scrutinize variable product replacement sales, overselling of enhanced riders, supervision of hypothetical illustrations, variable products within qualified plans, and market timing of sub-accounts." NASD's proposed Rule 2821, which formalizes the "best practices" for sales of deferred variable annuities announced years ago in NTM 99-35, may fix many of theses issues.

One regulator commented that variable products are "sold" by firms and not "purchased" by clients. Regulators' perception about "financially motivated" selling by registered representatives likely drives the focus on these products. For instance, in mid-2005, a member firm agreed to pay $5 million in fines and up to $11 million in restitution to more than 5,000 customers to settle charges relating to the firm's variable annuity switching campaign. Recently, this past March, NASD announced an action against a member firm that failed to comply with state insurance regulations, requiring pre-investment disclosures to investors in connection with replacement sales of variable life insurance and variable annuities. NASD had previously fined the firm for conducting prohibited sales contests that rewarded brokers for sales of selected variable products. Regulators have always despised sales contests and, frankly, such events make it easier for a regulator to prove an improper motive of a broker.

529 Concerns

NASD recently conducted a fact-finding sweep regarding sales practices surrounding 529 college savings plans. Afterward, NASD announced it had fined a member $500,000 for supervisory violations and ordered it to reimburse customers $750,000. In this case, the firm sold more than $1.1 billion of 529 plans over a three-year period without adequate suitability controls. Among other issues, the firm failed to consider state income tax benefits when making 529 sales. The result: customers purchasing plans who were not able to utilize state income tax benefits.

The Golden Rule

The best advice, although general, is to create a culture that encourages your sales force to put the client's interests first. It may not be all that is necessary to escape regulatory liability, but it is a great start in any defense.

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