Ketchum on exams, VAs and fiduciary standard

Jul 24, 2011 @ 1:37 pm

The following remarks were delivered June 28 by Richard G. Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority Inc., at the Insured Retirement Institute's Government, Legal and Regulatory Conference in Washington.

I'm pleased to have this opportunity to meet with all of you again this year to update you on some of what we're doing and thinking about at Finra. Today I want to talk about some of the changes we're making to our exam program, as well as an effort that's under way, related to the collection of variable annuity data and what we're seeing in variable annuity sales. I'll then touch on a back-office-registration rule that was recently approved. And I'll close with some issues that I think we all should be thinking about as the industry looks toward a fiduciary standard.


I'll start with the work we're doing on our exam program and our continued effort to make sure our exam teams are more focused on those areas that present a real risk to investors.

In the last year, we've added 20 more coordinators to our district staff for a total of 90 district staff dedicated to the surveillance function. Our goal is to have a much more in-depth understanding of your firms and how they are changing from the standpoint of business model, products and market events. We are also digging deeper on areas that pose the most risk. For example, we are using both paper and electronic means to verify that customer assets exist and are being held on behalf of customers in secure locations.

We are using more-sophisticated risk analysis to help ensure our examiners are asking the right questions when they walk in the door. To help target examination protocols, we are developing comprehensive profiles of a firm's business model and underlying risks. We will also be asking firms to provide detailed securities and financial transactional data, including purchase and sales data, customer data and data about the broker. For the last few years, we have been working with the largest carrying and clearing firms to receive data in a standardized format that enables us to test for compliance with the customer protection rule and to electronically perform comparisons to outside custodians.

Ultimately, we will work with the industry to develop standard data feeds that can be subjected to risk and compliance scenarios. These approaches will enable our examiners to be more effective when it comes to identifying the issues that deserve their attention.

Our examiners will devote more time to understanding risks and how well they are managed or mitigated. The new examination technology we are developing supports greater emphasis on open-ended risk-based reviews that require a more complete understanding of your business and the areas that are vulnerable to breakdowns in controls.

We are also paying closer attention to branch-level activity — increasing the number of branch exams and refocusing our exams at point-of-sale. The examination staff is spending more time on-site at the branch offices and, depending on the firm, less time at the main office. The point of sale and interface is where we have historically found troubling conduct, so we want to better target our resources. There will be a number of core areas that examiners will look at during these on-site examinations and likely engage in more dialogue with branch management as part of that process.

The combination of the qualitative information we collect through coordinators and our on-the-ground exam staff — and the quantitative information we gather through data collection and analysis — will better enable us to identify risk and decide where, how and with what intensity to apply our resources.

Looking ahead two to three years, there are several other changes that we are looking to make to our exam program. These changes are focused on broader data collection and more-sophisticated analysis of that data, with the goal of having our examiners better prepared when they arrive at firms.


As Finra works to focus its resources, we are also looking for opportunities to make it easier for firms to respond to our requests for information.

We know that those of you at insurance carriers, in particular, have concerns about the expense and effort associated with those requests. Many of you have told us it would be helpful if we could standardize requests. At the same time, the lack of access to variable annuity data has resulted in Finra examiners' manually reviewing documents, often on-site during a broker-dealer exam.

To address these issues, and as part of the exam program enhancements I mentioned earlier, we have launched a pilot program to collect data directly from the product underwriters and manufacturers using a standard request and template. The program focuses on products most frequently sold by retail firms.

We have created a template for collecting information that's been requested by examiners and investigators over the last couple of years, but this time, we ask for that information one way as opposed to any number of ways. We have continued to refine this template so that Finra can conduct rigorous reviews without further information requests from the product manufacturers, and firms are encouraged to use the template to provide information. We have worked closely with broker-dealer affiliates of the carriers to determine a data submission format that works for the industry and meets Finra's regulatory need. This is an ongoing process, and our ultimate goal is to develop a standardized approach.


Our first tranche of information requests was sent to carriers in April. Most of them have responded in a timely fashion, and the Finra team is reviewing the information and soliciting feedback on the information requested and the format. A second tranche of requests will go to additional variable annuity manufacturers in the next few weeks. This set of requests will utilize an updated template based on feedback and findings we received from the first set of responses. As we move forward, carriers will continue to have a seat at the table as we drive toward a data standard. We also are engaged with the Committee of Annuity Insurers and have reached out to IRI because of its important role in this area. Finra cannot go it alone here. We need industry engagement to drive toward a meaningful functional standard that works for all.

As I mentioned earlier, this pilot aligns with our overall goal to combine broader data collection with more-sophisticated analysis as part of our enhanced exam program. The objective is simple: We want to become more effective in spotting trends and in creating risk-based exams that go beyond the sampling approaches we have traditionally used, while over the long term, reducing costs and effort for the industry to obtain and use the information.

Now I'd like to turn to some of our recent exam findings related to variable annuities. The good news is that we're not seeing wholesale patterns of violations, and the industry has responded well to complying with our variable annuity rule. We are, however, seeing areas where firms still need to improve.

Let me give you some examples. One issue that we're seeing is failure to obtain — or failure to document — basic customer information such as age, annual income, financial needs, investment objectives and other critical information required under our VA rule and necessary for suitability analysis.

We've also seen inadequate policies and procedures, and inadequate supervisory reviews and approvals. And some firms haven't developed or properly implemented training programs under the rule.

While these findings may seem like minor traffic violations on the surface, variable annuities are very complex and sophisticated products, and firms need to have a level of supervisory control in place to ensure they're being sold properly.

From an enforcement perspective, we continue to have concerns, including abusive switches and costly surrender fees, firms' supervision of switch activity, inappropriate sales to seniors and overconcentration of annuity products in customer accounts.

That said, however, we are pleased with the industry's response to the variable annuity rule requirements. These requirements were considered and implemented over an extended period of time, were anticipated by the industry, and you all had time to prepare to ensure compliance with the rule. The small enforcement caseload also suggests that the rule, which requires training and principal approval of sales, has had the desired effect of deterring inappropriate sales of variable annuity products.


I'd like to turn now to an issue that Lee [Covington, senior vice president and general counsel of the IRI] specifically asked me to address, and that's the new rule requiring certain operations personnel to register with Finra and pass a qualifications exam. As you likely have heard, the SEC recently approved the rule, and while we will issue a regulatory notice announcing the effective date shortly, I'd like to preview some of the key provisions that were incorporated into the final rule filing and reflect comments from the industry.

First, let me talk about who is covered under the rule. We have clarified that covered persons do not necessarily need to be the most senior managers at the firm. Instead, the rule dictates that those who must register are the most senior managers with delegated direct responsibility for the covered functions in the rule.

Second, we have also clarified the level of managers below senior management who would be covered. Our filing indicates that those individuals designated as a supervisor or manager for the covered functions would be covered.

Third, with respect to introducing firms, Finra's expectation is that the scope of covered persons would be limited, given that the clearing firm would often be responsible for most, if not all, of the covered functions for the introducing firm. Therefore, the introducing firms might register a limited number of persons overseeing the relationship with the clearing firm, perhaps solely the [financial and operations principal].

The final area we've addressed in the rule filing is a grace period for individuals to pass the qualifying exam. The rule, as proposed, allows a 120-day grace period to pass a qualifying exam for both clearing and non-clearing firms that hired covered persons after the effective date of the rule.


The next issue I'd like to touch on is what all of you should be thinking about as momentum builds for a fiduciary standard.

Let's start with disclosure. While it's one of the key ingredients needed to address fiduciary issues, alone, it's insufficient. As I've said many times before — and I'm sure you'll agree — we need to get away from today's environment, in which account statements contain too much legalistic information, leaving them downright turgid and causing in¬vestors to simply ignore them. That is, in my mind, a fundamentally flawed approach to disclosure.

There are a few questions I suggest you address and ask with respect to relationships with your customers. How do we interact in an effective way with investors? How do we foster understanding among investors? And how do we deliver our message, both in terms of existing technology tools and our financial advisers?

It was for exactly that reason we published a concept proposal last fall designed to address these questions. The proposal would require firms, at or prior to commencing a business relationship with a retail customer, to provide a written statement that describes the types of accounts and services it provides. Firms would also be required to disclose the conflicts associated with such services.

How to disclose information, from accounts to conflicts, is really the challenge. We need to figure out the right combination of how to capture investors' attention upfront, how to provide detail from a web-based standpoint and how to use minimalist but effective point-of-sale disclosure to remind customers of the questions they should be asking again and again.

The result would be to move to an environment dramatically different than what we have had for the last 20 years. The presumption would be that you have conflicts and you have incentives, as all firms do. Knowing that, how would you provide disclosure and effective communication with customers so that they're able to make those decisions in a rational way? That's really the critical question, and one that I hope you and your colleagues will address in the weeks and months ahead.

In talking about disclosure, I would be remiss if I didn't acknowledge IRI's valuable work on developing a summary prospectus for variable annuities. This is an important example of the need to provide everyday investors with easy access to prospectus information, and I'm encouraged by the progress I've seen so far.


Before closing, I wanted to talk about an ongoing challenge that I know you are all struggling with: social media, and how to keep pace with disclosure and investor protection issues. In 2009, Finra organized a Social Networking Task Force composed of Finra staff and industry representatives to discuss how firms and their registered representatives could use social-media sites for legitimate business purposes in a manner that ensures investor protection. Based on input from the task force and others, Finra issued Regulatory Notice 10-06 last year.

The task force continues to examine some of the more recent questions and concerns involving social media. For example, firms have had questions about the best way to supervise “business card” information that is posted on a social-media site, particularly when there is the potential for employees to communicate about securities-related business through these sites. Firms have also questioned how they can most effectively supervise employees’ use of personal devices, such as smart phones, BlackBerrys and iPads which are able to access firm systems. The task force has discussed some broader Internet issues that extend beyond social-media sites, such as the use of hyperlinks from firm websites to third-party sites, and the use of third-party data on firm websites. Our goal is to provide further guidance on these issues in a notice to be published later this year. In the meantime, we welcome your input and look forward to working with the industry on social-media issues going forward.


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