In February 2012, Lake County, Calif. life agentGlenn Neasham was sentenced to 90 days in prison for selling anindexed annuity to a woman in her 80s, whom the prosecutor claimedwas unable to understand the product because she had early-stagedementia at the time of the sale in 2008. Neasham's license wasrevoked and, unable to support his wife and their four children, helost the family home.

The Neasham case sent chills up the spines of life agentsnationwide who also sell variable products. Of all the financialdecisions that came to light in 2008 and afterward, why was oneannuity sale with questionable suitability the top target forcriminal prosecution?

Related: Read the previous Castoriacolumn, ”Certain Uncertainty.”

Fast-forward to Feb. 4, 2013, a year after Neasham's conviction,when FINRA's new definition of suitability took effect. How willvariable annuity sales be treated under revised Rule 2111?

Three Levels of Suitability

Rule 2111 codifies and clarifies the three main suitabilityobligations that previously had been discussed largely in caselaw:

1. “Reasonable-basis” suitability. A broker must performreasonable diligence to understand the nature of the recommendedsecurity or investment strategy involving a security or securities,as well as the potential risks and rewards, and determine whetherthe recommendation is suitable for at least some investors based onthat understanding.
2. “Customer-specific” suitability. A broker must have areasonable basis to believe that a recommendation of a security orinvestment strategy involving a security or securities is suitablefor the particular customer based on the customer's investmentprofile.
3. “Quantitative” suitability. A broker who has control over acustomer account must have a reasonable basis to believe that aseries of recommended securities transactions, taken together, arenot excessive.

The new rule also broadens the existing list ofcustomer-specific factors that firms and associated personsgenerally must attempt to ascertain and analyze when makingrecommendations to customers. The new rule adds a customer's age,investment experience, time horizon, liquidity needs and risktolerance to the explicit list of customer-specific factors fromthe earlier rule (other investments, financial situation and needs,tax status and investment objectives).

The reference to the “investment strategy” is new, and accordingto FINRA, the term is to be interpreted broadly. It need notmention a specific security; the recommendation of a specificmarket sector can be an “investment strategy.” Recommendations canalso include advice to hold, purchase or sell currentsecurities.

However, FINRA's interpretive material clarifies that silence bya broker is not a “recommendation” to hold a security. In contrast,former NASD Rule 2310(a) stated that when recommending “thepurchase, sale, or exchange of any security,” a member had to have“reasonable grounds for believing that the recommendation issuitable for such customer upon the basis of the facts, if any,disclosed by the customer.”

More generic communications may not be “recommendations.” Acommunication that explains basic concepts such as diversification,inflation or asset classes is not a recommendation. An assetallocation model that is based on a generally accepted investmenttheory and is accompanied by appropriate disclosures does notconstitute a recommendation.

When Does an Idea Become a Recommendation?

But what about casual conversations with clients? Imagine thefollowing discussion at a coffee shop:

Justin Case, licensed life agent andsecurities representative: So, Fred, when are you going to leavethe rat race and move to that cabin by the lake that you alwaystalk about?

Fred Hurtz, engineer: I still talkabout it, especially on days when the rats seem to be winning therace. But there are still 10 years to go on my mortgage. Ifanything happened to me, Zelda would need that money.

Justin: You know, Fred, there arevariable annuities that provide a death benefit, so that in caseyou are “out of the picture” your beneficiary is guaranteed thatyour original money gets replenished, even if the investments heldin the annuity have gone down. I'm selling that sort of annuity toa lot of folks in your situation, from a good company calledGangreen Insurance, the “GG20-20 policy.” It lets you allocate themoney into different classes, too, so you don't have all your eggsin one basket. If you'd care to drop by my office, I could show youan illustration.

Has Justin made a recommendation to Fred? Justin mentioned aspecific product and described a few of its features, though notall of them. The new suitability rule could be stretched far enoughto apply to this communication, though that would be an unrealisticand harsh standard for an impromptu and very preliminary marketingpitch.

Read another Castoria column, “When Wrecking BallsStrike.”

What if Justin had gone a bit further in his salesmanship, andtalked about a special “blend” of subaccounts that he recommendsfor all his variable annuity clients who are in Fred's age group?That would be a closer question because the conversation would havebecome quite specific, and at the level of a specific investmentstrategy based on Justin's own selection of subaccounts.

Heightened Suitability Obligations for DVAs

Even before the new definition of “suitability” went intoeffect, FINRA had required—and still does—special care inrecommending purchases and exchanges of deferred variable annuities(DVAs) and recommended initial subaccount allocations (FINRA Rule2330; the rule does not apply to reallocations nor to transactionsin a tax-qualified or ERISA benefit plan).

In summary, Rule 2330 requires that the broker determine thatthe customer has been informed about DVAs in general, andspecifically about surrender period charges; potential taxpenalties for sales or redemptions before reaching the age of59½; mortality and expense fees; investment advisoryfees; potential charges for and features of riders; insurance andinvestment components; and market risks.

If a particular DVA is being recommended, the broker mustreasonably believe that the customer understands the same featuresof that DVA and the recommended subaccounts, and they are suitablefor the customer. Rule 2330 also applies when one DVA is beingexchanged for another and imposes additional obligations on thebroker.

To address the entirety of Rule 2330 would take severalarticles. Since our focus is on the initial “recommendation” to thecustomer, as that term is now redefined by FINRA, we will simplypoint out that there are also additional requirements forsupervisory approvals, record keeping, training and other aspectsof DVA transactions.

Between a Rock and a Hard Place?

How can an individual agent or broker navigate between the rockyshoals of inadequate disclosure on one hand and potentiallymisrepresenting the terms of the variable product on the other?Simply reading the variable contract aloud, word for word, isimpractical, and most customers would later say, “He lost me afterthe first paragraph.”

FINRA provides some guidance as to how to communicate with thepublic about variable products (Interpretive Material IM-2210-2 onfinra.org), but following that guidance does not inoculate theagent or broker against the claims of customers orbeneficiaries.

The representative's best allies against such claims are thefirm's compliance department and thorough, updated trainingprovided by the firm. Checklists that are specific to the variableproduct and preapproved by compliance can be useful tools to helpensure that the key features of a given product have beendiscussed, including the potential benefits and the risks.

Variable life and variable annuity products are more complexthan some other investments, less so than others. The role of theagent or broker is as much that of an interpreter as an adviser;the unique jargon of variable products can be daunting to a newcustomer. That's ironic in that the product can actually simplifythe customer's overall financial health by creating a platform inwhich the product mix can readily be adjusted, without piled-oncommissions and charges, to meet changing needs or changingmarkets.

Read “Fiduciary: Underrated Risk?” by LouieCastoria.

In FINRA arbitration proceedings brought by customers, one wordin that last paragraph looms large: “commissions.” The customer'sallegation will invariably include an accusation that theagent/broker recommended a variable product only because theup-front commissions were larger than for mutual funds, stocks,bonds and some other products. The balance between the higherinitial commission and the small or entirely absent commission andcharges for changes in the variable product's subaccounts andallocations should be made clear from the outset and confirmed inwriting, in a manner that the compliance department hasapproved.

In simplifying the customer's financial picture, the agent orbroker needs to avoid “complex-ifying” his or her own.Understanding the lay of the regulatory landscape, receivingupdated training and working together with the firm's in-houseexperts are the best ways to do so.