New York Securities Fraud Lawyers Blog
We have previously written on the concept of “churning,” which is a fraud perpetrated by brokers who buy and sell securities for the primary purpose of generating a commission, and where that activity would be considered excessive in light of the investor’s investment goals. But is it possible to have a churning claim when a broker sells you an insurance product or recommends swapping out one variable annuity policy for another? And can a single transaction be considered “excessive” in the context of a churning claim? The answer to both of these questions is yes.
The law appears to provide an opening for churning claims when it comes to investors, and in particular retirees, who find themselves “stuck” with an illiquid annuity in their portfolio. Retirees, who tend to need access to capital more than other segments of the population (due to not working and the increased medical costs associated with getting sick and old), are often sold unsuitable variable annuities, which can tie up retirement funds for decades. Technically the investor can get of the policy, but not without paying significant IRS tax penalties and steep surrender charges, sometimes as high as 10% to 15%. Sadly, these costs and product features are often misrepresented and go undisclosed at the point of sale.
While not all annuities are considered securities under the law, variable annuities certainly are securities. The SEC requires the seller of a variable annuity to possess a Series 6 or 7 brokerage license with the Financial Industry and Regulatory Authority (FINRA). Variable annuities can be distinguished from fixed annuities in that their returns are not fixed, but rather determined by the performance of the stock market. One characteristic of a variable annuity policy is that you get to choose a fund to invest in, much like you would with a mutual fund. Variable annuities are highly complex investment products. They are also costly to investors, in part because of the high commissions they generate for the brokers who sell them. Regardless of whether you were sold a variable annuity or some other type, it should be noted that FINRA requires its member brokerage firms to monitor all products sold by their brokers.
FINRA Rule 2111, the Suitability Rule, specifically requires brokers to sell products that are suitable for each investor. Supplementary note 2111.05 of this rule, which describes the concept of “quantitative suitability,” suggests that an investor could have a viable churning claim even in circumstances where there are a limited number of transactions:
“Quantitative suitability requires a member or associated person . . . to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer’s investment profile, as delineated in Rule 2111(a). No single test defines excessive activity . . ..”
Excessive activity is thus not only subjective, but the law certainly suggests that it would require a broker to have a reasonable basis for recommending the replacement of one variable annuity with another, no different than with any other broker recommendation.
While sometimes there are valid reasons to exchange annuity policies, there are often more reasons to react with extreme suspicion when a broker recommends doing so. Your point of inquiry should start with whether the policy is better for you or better for the broker. It cannot be overstated that variable and indexed annuities have exorbitant commissions, often as high as 7% up front, not to mention include many other hidden fees and rider costs, all of which eat away at your return and the total benefits you would otherwise receive.
You should further consider that a recommendation to swap policies is possibly an admission by the broker that the first policy was unsuitable for you. Investors unaware of the high commissions in these products might also be enticed to swap annuities because their brokers led them to believe that there are no tax consequences for doing so, thanks to the 1035 Exchange rules of the IRS. But FINRA has warned that “this tax benefit comes with some important strings attached.”
FINRA also requires firms and their brokers to complete a thorough suitability analysis specifically when recommending annuity exchanges:
“Replacing one [Variable Annuity] with another involves a comparison of the complex features of each security. In doing so, a firm and its registered representatives must compare costs and guarantees in a way that is complete and accurate… In any case, you should exchange your annuity only when it is better for you, and not just better for the person trying to sell you a new annuity.”
FINRA’s enforcement division has repeatedly cracked down on firms who have failed to perform this suitability analysis when swapping policies. In 2016, for example, FINRA sanctioned MetLife Securities $25 million in connection with the firm’s omissions and misrepresentations concerning the replacement of variable annuity contracts. For the many thousands of customers of MetLife, the firm, over a six-year period, essentially “rubber stamped” the approval of these replacement variable annuity contracts at an astounding rate of 99.79%. This is indicative that MetLife failed in its suitability obligations, as the firm and its brokers could not have possibly performed any meaningful suitability analysis in a “complete and accurate” manner. Quantitative suitability analysis, particularly as it relates to variable annuities, also remains at the very top of FINRA’s enforcement priorities, as stated in its recently released 2019 Risk Monitoring and Examination Priorities Letter:
“As always, suitability will remain one of FINRA’s top priorities. This year, some of the specific areas on which we may focus include: (1) deficient quantitative suitability determinations or related supervisory controls; (2) overconcentration in illiquid securities, such as variable annuities, non-traded alternative investments and securities sold through private placements….”
Some investors like annuities because they take the “thinking” out of investing, particularly where a broker promises a guaranteed return of any kind. In an age where few of us have pensions, annuities are attractive to investors who want to set up their retirement to provide regular payments. But annuities – especially variable and indexed annuities – are highly complex, costly, and among the most misunderstood types of investment products. Brokers and firms are not only responsible for determining an investment’s suitability for your needs, but clearly explaining all the costs, benefits, and risks associated with a product. Considering how complex variable annuities are, it is rare to find retail investors who fully understand these products, much less the brokers themselves. For this reason, many investors may have an additional claim against brokers and their firms for any material omissions at the point of sale. If you feel that your broker misled you in the sale or swapping of a variable annuity, you should speak with a knowledgeable attorney who can review your case.