NASD NTM 06-38: Life Settlements

Originally published September 19, 2006

NASD issued a Notice to Members ¹ ("NTM 06-38") reminding firms and associated persons that life settlements involving variable insurance policies are securities transactions subject to NASD rules. This NTM follows other recent Notices regarding insurance product sales practices and serves to highlight the continuing regulatory scrutiny over this area.²

The Notice steers clear of characterizing life settlement transactions in either a positive or a negative light. Rather, it expresses a concern that the growth of the life settlement market will lead to increased competition resulting in aggressive marketing and inappropriate sales. The Notice highlights various obligations that the NASD rules impose on brokerage firms and registered representatives engaged in variable life settlement transactions.

The Notice refers to the life settlement market as "a secondary market for existing life insurance policies." According to the Notice, a life settlement is where an owner of a life policy sells the policy to a third party. Typically, the owner would get less than the policy’s death benefit but more than the policy’s cash surrender value. The Notice further explains that a common scenario is where an insured sells his or her policy to a life settlement provider, which either holds the policy to maturity and collects the death benefit or sells the policy or interests in multiple, bundled policies to hedge fund or other investors. The Notice further points out that some life settlement providers have begun to aggressively encourage broker-dealers to "canvass their books of business for seniors or other eligible customers who may be interested in selling their life insurance policies in the secondary market, even if they do not need to or had not previously considered surrendering or allowing their policies to lapse."

The Notice covers the obligations of firms and their associated persons in connection with recommending or facilitating a variable life settlement. It discusses, in turn, the following areas: suitability, due diligence, best execution, training and supervision, and compensation.

The Notice states that, while a variable life settlement may be a valuable option for some, it is not an appropriate option for others. With respect to suitability, the Notice cautions:

• There can be significant costs associated with a settlement transaction and such a transaction is not necessarily suitable for a customer simply because the settlement price offered exceeds the policy’s surrender value;

• In addition to settlement price, other relevant factors may include the customer’s continued need for coverage, and, if the customer plans to replace the existing policy with another policy, the availability, adequacy and cost of comparable coverage; and

• Depending on the circumstances, including the customer’s stated financial needs and investment objectives, firms also may need to consider the basic tax and other relevant implications of selling a variable policy.

The Notice points out that in addition to the general due diligence required regarding the terms and conditions in connection with any securities transaction, the unique nature of variable life settlements poses certain special concerns. In this regard, the Notice advises that firms and associated persons:

• Understand the confidentiality policies of the providers or brokers with whom they are doing business;

• Understand and be able to explain to their customers any ongoing obligations the customer will incur (e.g., providing notification of significant medical developments);

• Consider establishing a list of approved life settlement providers and/or brokers whose policies and practices are consistent with the firms’ obligations to its customers; and

• Not recommend variable life settlements that involve life settlement providers and brokers that are not properly licensed where such licenses are required.

In the area of best execution, the Notice cautions firms recommending or facilitating a variable life settlement to make certain that they meet their obligations under NASD Rule 2320 ("Best Execution and Interpositioning"). The Notice observes:

• The core duty pursuant to the best execution obligation is to use reasonable diligence first to ascertain the best market for the security, and then to obtain the most favorable price possible in that market under prevailing market conditions. Price is only one component of best execution. Other factors include the speed and quality of execution, and the reliability of the other market participants.

• Firms must develop their own policies and procedures for ensuring best execution in the context of variable life settlements.

• Firms recommending that a customer sell a variable life insurance policy should make reasonable efforts to obtain bids from multiple licensed providers, either directly or through a life settlement broker. In this regard, the Notice warns that an exclusivity arrangement between a firm or an associated person and one life settlement provider would generally be inconsistent with the firm’s best execution obligations.

• Given the rapid developments in the life settlement market, firms should regularly review their best execution policies and procedures to ensure that they continue to satisfy Rule 2320.

The NTM cautions firms to establish an appropriate supervisory system to ensure that their associated persons comply with all applicable NASD and SEC rules when recommending or participating in the sale of variable life insurance policies in the secondary market. In this regard, the NTM indicates that firms should:

• Ensure that their written supervisory procedures require that the appropriate reasonable-basis suitability analysis is completed before transactions are recommended; associated persons perform appropriate customer-specific suitability analysis; all promotional materials are accurate and balanced; and all NASD and SEC rules are followed.

• Document the steps they have taken to ensure adherence to its written procedures.

• Comply with NASD Rule 3040 ("Private Securities Transactions of an Associated Person") to the extent that an associated person participates in a settlement involving a variable life insurance policy outside the regular course or scope of the associated person’s employment with a firm.

The Notice also reminds members that any compensation received by associated persons in connection with recommendations to sell a variable life insurance policy must comport with Rule 2820(g). However, the NTM provides no guidance regarding how a non-cash compensation incentive plan would take into account life settlement compensation.

While NTM 06-38 addresses the obligations of NASD members and associated persons regarding variable life settlements, it also advises that the NASD is concerned about the involvement of members and associated persons in the subsequent marketing and sale of interests in traditional life insurance policies. In this regard, the Notice points out that depending on the circumstances, firms participating in the sale and marketing of interests in life insurance policies (variable or not) for investment purposes may trigger broker-dealer registration requirements under the Securities Exchange Act of 1934.

Finally, the Notice advises that the NASD will continue to monitor this emerging market closely and will take appropriate action or issue further guidance as necessary.

1 Life Settlements, NASD Notice to Members 06-38 (August 9, 2006).

2 See e.g., NASD Notice to Members 05-50 (Equity-Indexed Annuities; Member Responsibilities for Supervising Sales of Unregistered Equity-Indexed Annuities, August 8, 2005) and NASD Notice to Members 04-45 (NASD Seeks Comment on Proposed Rule to Impose Specific Sales Practice Standards and Supervisory Requirements on Members for Transactions in Deferred Variable Annuities (June 9, 2004).

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.