Compliance Issues Affecting Mutual Funds And Indexed Annuities

Editor: Tell us a bit about your background.

Choi: I'm a native Washingtonian and have been practicing law in this area for nearly 20 years. I graduated in 1987 from the University of Virginia Law School. Prior to that, I attended the University of Chicago.

Editor: Why did you decide to focus your talents on the financial services area?

Choi: I had an abiding interest in securities law, which may well be attributable to the fact that I had a great securities professor in law school. I signed up early in my career with a firm that had a terrific mutual fund and investment adviser practice. The mutual fund industry has been a great success story. It has grown from a half trillion dollars when I graduated from law school to over nine trillion dollars today. What makes this field so attractive to me is that I have an opportunity to work with smart creative people dedicated to growing other people's assets. Millions of people depend on the products and companies that I work with for their retirement. With the leading edge of the Baby Boom generation starting to retire, there is an acute focus on the financial aspects of retirement.

Editor: Why did you and others doing similar work at the same mega firm decide to join Jorden Burt?

Choi: I had a great experience at the mega firm, where I headed up its financial services and products practice. My current firm is the proverbial 800 pound gorilla in the financial services space because it is able to devote focused attention to issues affecting the insurance, mutual fund, and financial services industries.

An important strength of Jorden Burt is its litigation and enforcement practice. The firm's litigators have handled hundreds of individual and class action cases affecting the financial services industry. In an environment where so much current focus is on enforcement and litigation, it is great to have colleagues with that experience as an integral part of the team. Their experience helps to inform my counseling practice generally - and the early warning signals they provide about the strategies and targets of plaintiffs' counsel and prosecutors enable my clients to avoid potential shoals.

Editor: Why is compliance particularly important with respect to the investment products involved in your practice?

Choi: Mutual fund and life insurance company products are the cornerstones of our practice and the cornerstones for the retirement of millions of Americans. It's important that people understand what they are buying and how the products work. It's also important for the products to do what they're supposed to do. Compliance is crucial to both.

Now, no industry, including financial services, is immune from the potential bad actors out there. Although the regulatory framework in which financial services operate is comprehensive, and the market participants generally are committed to good practices, the fraudsters out there tend to be innovative. Fortunately, because they invest significant resources in compliance, the mutual fund and life insurance industries have done a terrific job of fulfilling their roles as stewards of other people's money.

Editor: What is the hottest compliance issue?

Choi: The hottest compliance issue for any company is the issue that it didn't see coming and isn't prepared to deal with because it didn't properly assess its operational risks in advance. Market timing is a classic example of such an operational risk failure. Market timing involves rapid trading in and out of a fund, which makes it hard for the fund's portfolio manager to continue to implement his or her investment strategies because of the need to keep large reserves of cash on hand to cover redemptions. A fund's ability to generate returns can be undermined if too much of the fund's assets is held in cash to cover redemptions by short term traders. The regulators were well aware of abusive market timing activity, which the industry had for many years openly complained about, but it became sort of an accepted problem given that funds couldn't readily identify the timers nor could they involuntarily kick them out by redeeming them. The mindset of market timing activity as an unavoidable nuisance caused people to drop their guard and cracked opened the door for really egregious behavior, such as allowing market timers to time particular funds so long as they left "sticky" assets, on which the adviser would earn fees, in other funds. It's imperative in today's environment for companies to proactively identify, evaluate, and mitigate their risks.

Editor: Some of the alleged abuses have been defended as "industry or market practice."

Choi: You will often hear that a practice is "industry or market practice." You can't properly advise your clients if you take these kinds of statements at face value. If nothing else, market timing proved the point that even where a practice has become widespread, it may still give rise to noncompliance. When advising clients about a particular practice, you owe it to them to exercise your independent professional judgment and carefully examine the facts and circumstances in order to opine on the legal risks involved.

It is important to balance the desire for growth against the ethical imperative of assuring that customers are receiving the benefits of the products they thought they were buying. Sometimes you have to rein in the marketing department to make sure that things are done in a way that protects the interests of customers.

As a securities lawyer one of the hardest answers you can give is "no" because you don't want to incorrectly impede or shut down a potentially lucrative distribution initiative or valuable product line. At the same time you cannot liberally say "yes" just to mollify your clients' marketing department. It is very important that you exercise independent judgment and be thoughtful in your answers. In some cases you need to speak with regulators to make sure that laws are in fact being applied in a manner consistent with your interpretation.

Editor: What compliance issues arise with respect to products that may be subject to the jurisdiction of both insurance and securities regulators?

Choi: One area of concern involves indexed annuities. These are insurance products, not securities. Recently, however, the National Association of Securities Dealers, Inc. (NASD), which is primarily responsible for regulating broker/dealers who sell securities, expressed the view that indexed annuities may be securities and warned broker/dealers that, if they deal with these products, they should treat them as securities.

The most important compliance issue for indexed annuities is to ensure that they are designed, administered, and marketed in a manner consistent with their non-security status. Contract terms must comply with applicable regulations and relevant judicial precedent. Marketing materials must be carefully reviewed to ensure that the emphasis is on the insurance and retirement features as opposed to the investment features.

Editor: Are there general compliance concerns that apply to all investment products?

Choi: A common compliance issue for the brokers and representatives who sell financial products is suitability. Simply put, suitability means making sure the financial products being sold are right for the customer. It is important to match the interests and needs of the clients with the products being sold. Suitability involves making sure there are appropriate disclosures about the products and making sure your sales reps understand what it is that they're selling.

Editor: Have you worked with court appointed monitors?

Choi: We have served as independent consultants in connection with a number of regulatory enforcement actions. The purpose of involving independent consultants is to provide regulators, such as the SEC, with an unbiased third party assessment of a company's existing practices and to provide independent scrutiny of a company's ongoing operations. It gets the regulators out of having to micromanage a company's business - which is a good thing. Everyone in the industry should share the common goal of doing right for the customer - and independent monitors help to serve that purpose.

Editor: Do you help companies set up compliance training programs for their personnel?

Choi: We do a lot of that work. We help develop and review compliance training materials, and our lawyers provide onsite training programs for our clients, including back office administrative people, lawyers and compliance staff, and even sales and marketing personnel. We also help clients determine what kind of compliance system they should institute or to fine tune an existing system. Finally, we also perform legal audits to substantiate the effectiveness of a compliance system. We follow the money and document trails to be sure the system is working properly. All those aspects of compliance are crucial supports to dynamic and robust sales.

Published October 1, 2006.