(Article reprinted by permission from Money Media)

CHICAGO - May 26, 2005 - Mutual fund and variable annuity issues still top the NASD's enforcement priority list. That includes sales of fund B shares, breakpoint discount issues, and sales suitability of products, especially equity indexed annuities. That's according to some of the NASD's top cops who shared a peek at the group's enforcement agenda at the NASD Spring Securities Conference.

"Mutual funds continue to be an area of great interest," said Jim Shorris, senior vice president and deputy of NASD enforcement. "We have had some B-share cases already, but there will be more this year."

Shorris was referring to several enforcement actions against brokers who sold customers B shares when A shares would have been a cheaper option. The NASD has been focusing on such cases. B shares typically have higher ongoing expenses while A shares have lower annual fees but higher up-front costs. A shares also often offer volume discounts, called breakpoints, which can further reduce charges. So for investors with a long time horizon, A shares are usually less expensive.

Breakpoints are another sensitive issue that the NASD is going to continue monitoring closely. Jeff Holik, senior vice president of NASD Member Regulation, said that inspectors will look closely to make sure that investors are receiving breakpoint discounts.

"In examinations, our examiners routinely conduct their own analysis of the class of shares that has been recommended and look at how breakpoints would apply," he said. "They scrutinize transactions from a net cost basis."

More than two years ago, a study conducted by the NASD, SEC and New York Stock Exchange discovered that one third of all fund clients at 43 different brokerages had not been given the breakpoint discounts to which they were entitled. That sparked an industry-wide examination followed by enforcement action.

Sales suitability would also be a key area of focus, continuing a trend from 2004, Holik said.

"Suitability is always in our top 25 rule violations," he said. "About half of those cases involve general suitability issues, such as not having adequate documentation to conclude that an investment is appropriate for a particular customer."

Many suitability cases involve variable annuities. Because the products lock up money for a long period of time and levy surrender charges on early withdrawals, they're usually not appropriate for those seeking more liquid investments. The elderly, for example, are typically not ideal VA customers, although there are exceptions.

Equity indexed annuities (EIAs), said Shorris, are a particular problem. The annuities provide a guaranteed fixed return, but also offer some upside tied to the market. The SEC hasn't definitively ruled yet on whether or not it considers them to be securities, so many insurers are treating them as insurance products, which are outside the regulatory scope of the NASD.

Shorris said that argument doesn't always hold.

"If they're being held out and sold to customers as investments, then they're viewed as securities," he said. "Our communications rules would apply."

Also, he said, if a rep encourages a client to switch from a security to an EIA, the NASD will evaluate the suitability of that switch.

Other areas that the enforcement group is looking more closely at include gifts and gratuities offered to brokers in exchange for selling products, and suspicious activity reports (SARs).

Brokers must file SARs on transactions that seem suspicious to help prevent money laundering and terrorist financing. Although a similar mutual fund requirement is in the works, it hasn't yet been finalized. Shorris said he's concerned that broker-dealers aren't filing the reports when they should.

There are some bright spots in the NASD's enforcement program, however.

Executive vice president of enforcement Barry Goldsmith said the regulator has streamlined its sweep inspection process.

"We've heard the industry loud and clear," he said. "We recognize that letters like this do impose a burden".

But, Goldsmith said, sweeps are an important part of its activities because they allow the NASD to look at a lot of firms at once and place them in a pecking order in terms of problems. So now, he says, the NASD has moved to a centralized approach.

"Before any group sends out a sweep request, they have to go through a pre-approval process," said Goldsmith. "We're also trying to limit the number of firms involved and not hit the same ones all the time."

In an effort to coordinate the NASD's sweep activities with those of other regulators, Goldsmith said, the self-regulatory organization is encouraging registrants to report similar efforts from other groups.

Ben Indek, a partner with Morgan, Lewis and Bockius, said that firms should also try to work with the NASD on document production if they're having difficulty meeting the regulator's requests. That could mean, he said, offering alternative documents that contain similar information or scheduling rolling production of documents to supply easier-to-find records first.

However, Anne Flannery, first vice president and general counsel of global regulatory affairs at Merrill Lynch, said that the NASD's sweep system is still burdensome.

"In the last several months, the NASD has gotten a lot better, but there are still problems," she said. "Sometimes, firms are confronted with extraordinary requests that arise without any collaboration or guidance from the industry."

She noted that it's not always possible to negotiate alternatives when a document production letter specifies exactly which records must be sent, how they should be formatted and how long a period of time is involved.

"It might be useful instead to sit down with firms and say, 'Here's the issue we want to grapple with, what's the best way to extract the information?'" she suggested.

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