The New Frontier- Retiring Baby Boomers and the Senior Market

From PLI’s Course Handbook

Securities Arbitration 2008: Evolving and Improving

#14310

the new frontier: retiring baby

boomers and the senior market

Thomas A. Roberts

Barrasso Usdin Kupperman Freeman &
Sarver, LLC

Special thanks and credit to Catherine E. Garas

Who was instrumental in preparing this chapter.

The New Frontier: Retiring Baby Boomers and the Senior Market

Thomas A. Roberts *
Barrasso Usdin Kupperman Freeman & Sarver, LLC

* Special thanks and credit to Catherine E. Garas who was instrumental in preparing this chapter.

Baby boomers are aging, and that reality could bring an exponential increase in securities arbitration filings. This chapter will put that probability into perspective.

It is projected that by the year 2012 roughly 10,000 Americans will turn 65 each day. By 2030, the US Population aged 65 years and older is expected to double to over 71 million. [1] At that time 20% of the population will be 65 years or older.[2] As baby boomers approach the dawn of their retirement, they have more than $8.5 trillion in investable assets, and stand to inherit roughly $7 trillion from their parents.[3] However, due to the decline in traditional corporate pension plans and the strain on social security, baby boomers have had to take more responsibility for planning for their financial futures. Accordingly, in increasing numbers, baby boomers and seniors are turning to investment professionals to establish secure, profitable plans for their golden years.

The exploding senior population has created numerous opportunities for brokerage firms, investment advisors and financial planners. However, with opportunities for growth also come responsibilities for protection. Senior citizens are increasingly becoming targets of fraud and financial abuse. Consumer Action, a consumer advocacy group, estimates that people age 60 or over represent 30% of fraud victims.[4] Not surprisingly, regulators, legislatures and senior advocates are turning to financial institutions to implement supervisory initiatives directed at detecting internal practices which may mislead or exploit senior citizens. Moreover, financial institutions are often looked at as the first line of defense in policing non-affiliated third parties. This is the time, more than ever, for self-regulation to come to the forefront of brokerage firm and individual investor protection. For, as a seasoned compliance officer once told me, the touchstone of effective supervision is the protection of both the investor and the firm. When supervision fails, arbitrations likely follow.

The Regulators’ Senior Initiative

Concerned that financial scams targeting seniors will rise with the aging population, the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority (“FINRA”)[5], and the North American Securities Administrators Association, Inc. (“NASAA”)[6] have joined together in a national initiative aimed at protecting seniors from investment fraud and sales of unsuitable securities (the “Senior Initiative”). The Senior Initiative, announced in May 2006, includes three components: (1) targeted examinations to detect abusive sales tactics aimed at seniors, (2) aggressive enforcement of state and federal securities laws in cases involving seniors, and (3) investor education and outreach. [7]

As part of the Senior Initiative, the SEC, FINRA and NASAA have combined their resources, connections and expertise to initiate five major “sweeps”. Regulators use “sweeps” or targeted investigations to gather information and carry out investigations into certain sales practices which have gained regulatory attention due to recent enforcement actions or civil actions. The investigated firms are selected based on a variety of factors, including level and nature of business activity in a particular area, customer complaints, regulatory history, and prior examination findings. Under NASD Rule 8210, member firms are obligated to cooperate with all such investigations, and provide any documents or records requested.[8]

The five senior “sweeps” address the following areas of regulatory concern: (1) “free lunch” seminars targeting the senior market; (2) professional designations or titles that use the terms “senior” or “elderly” or imply that a person has special expertise, certification, or training in advising or servicing senior citizens; (3) early retirement seminars designed to entice older workers to retire early, liquidate their retirement funds, and invest them with a particular registered representatives; (4) sales of principal only, interest only and inverse floater tranches of collateralized mortgage obligations to seniors; and (5) marketing life settlements to seniors. An overview of each sweep follows:

“Free Lunch” Seminars

The first sweep was directed at the use of “free lunch” seminars, whereby investment advisors invite investors to attend sales seminars by offering a free meal at upscale locations. Such sales seminars are widely offered by firms looking to sell financial products. They are often advertised in mass-mail invitations, mass email, local newspapers and on websites. According to a recent FINRA survey aimed at senior fraud risk, identified victims of fraud were three times more likely to have attended a “free lunch.” seminar.[9]

The regulators conducted 110 on-site examinations between April 2006 and June 2007. Examinations were targeted in areas of the country that have a large retiree population (i.e. Florida, California, Texas, Arizona, North Carolina, Alabama and South Carolina). These examinations were designed to review firms that offer sales seminars targeted to seniors and retirees for compliance with securities laws and rules intended to protect seniors.

After completing an extensive sweep that spanned 15 months, the regulators issued a joint report entitled “Protecting Senior Investors: Report of Examinations of Securities Firms Providing ‘Free Lunch’ Sales Seminars.”[10] The report includes findings that while the seminars were often advertised as educational and unbiased, ultimately they were designed to use aggressive and high pressure sales tactics to pitch proprietary or affiliated products for which the presenter receives compensation. The joint investigation found that 57% of the firms used advertising and sales materials that may have been misleading or exaggerated or included seemingly unwarranted claims, and that 23% involved recommendations that seniors invest in unsuitable investment products. Fourteen percent of the examinations revealed conduct which may have constituted outright fraud.

The report highlights a lack of supervisory oversight and compliance procedures to address practices which could violate numerous securities laws and FINRA rules of conduct. Remarkably, only 4% of the examinations (5 of the examinations conducted) ,revealed no deficiencies or problems. Most importantly, and in order to help brokerage firms improve their supervisory and compliance practices in these areas, the report includes a description of compliance and supervisory practices that appeared to be effective in ensuring adequate supervisory procedures. Among the commended practices were a centralized system for reviewing and approving proposed seminars, advertising and sales materials, using standardized, pre-approved presentation materials, advertising and sales literature for the seminars and having registered principals or “mystery shoppers” randomly attend the seminars.

While the recommended practices are not specifically mandated by the securities laws, they do provide investment professionals with a blueprint of possible changes or improvements to their supervisory and compliance systems. Ultimately, each firm must evaluate its business model, firm culture and resources to determine the appropriate means to keep a strong arm on this issue.

In an effort to educate investors about the concerns with “free lunch” seminars, both FINRA and the SEC have issued Investor Alerts which are available on their websites.[11] These notices encourage investors to take a critical view of such seminars, cognizant of the fact that even if the seminar is framed as an educational event, it is designed to market products. Regulators encourage attendees to do their homework before the seminar, to ask questions at the seminar and to resolve in advance not to be pressured into making any investment decision at the seminar itself.

Professional Designations

Regulatory attention is also focused on the use of “professional” designations to mislead and defraud senior investors. The Senior Fraud Survey conducted by FINRA found that a quarter of seniors surveyed were told that their investment professional was specially accredited to handle seniors’ financial issues.[12] Those investors reported that they were more likely to listen to the advice given because of such “specialized accreditation.”

As a result of the first stage of the enforcement investigation, regulators found that investment professionals were using 50 different senior designations. The criteria for obtaining senior designations vary greatly. Some designations require formal certification, including completion of a rigorous course on financial issues, culminating in at least one examination, ethics requirements and ongoing continuing education requirements. However, others require nothing more than the payment of membership dues. Still others involve “educational” requirements focused more on learning how to break into the senior market, than protecting senior advisors. The three most popular designations are “Chartered Retirement Planning Counselor (“CRPC”), Certified Senior Advisor (“CSA”) and Chartered Advisor for Senior Living (“CASL”). These designations are usually on the person’s business card or stationery.

In addition to the FINRA sweep, state lawmakers are taking measures to curb misleading senior designations. In 2007, Massachusetts became the first state to issue regulations relating to senior designations. Effective June 1, 2007, Massachusetts forbid an investment advisor from using “purported credential or professional designation that indicates or implies that a broker-dealer agent has special certification or training in advising or servicing senior investors, unless such credential or professional designation has been accredited by an accreditation organization recognized by the Secretary by rule or order.” [13]In June 2007, the Secretary of the Commonwealth of Massachusetts issued two orders recognizing the American National Standards Institute and the National Commission of Certifying Agencies as accreditation organizations.

On January 1, 2007, the Nebraska Department of Banking and Finance went so far as to issue a “Special Notice” requesting firms to prohibit the use of professional designations that state or imply a specialized knowledge of the needs of senior investors.[14] On July 31, 2007, the department issued Interpretive Opinion No 26, which lists approved designations by investment advisors and comments that use of designations not listed in the opinion may result in administrative action.[15]

Most recently, on April 1, 2008,the Missouri’s Secretary of State Robin Carnahan announced a new rule which will limit professional designations used by investment advisors and broker dealers in Missouri to those recognized by a nationally recognized accreditation organization.[16]The filed rules are subject to the state regulation filing process and would go into effect on January 1, 2009.

In addition to actions taken by individual states, NASAA recently announced that its membership approved a new model rule prohibiting the misleading use of senior and retiree designations.[17] On April 1, 2008, Karen Tyler, NASAA’s president, urged all NASAA members to adopt it into their jurisdictions as soon as possible. The model rule prohibits the misleading use of senior and retiree designations, while also providing a means by which the state securities administrator may recognize the use of certain designations. The model rule resulted from the collaboration of the state securities administrators and the SEC.

Federal legislatures are taking steps to encourage states to adopt the NASAA model rule. On April 1, 2008, Senator Herb Kohl (D-Wisconsin), Chair of the U.S. Senate Special Committee on Aging, introduced a bill entitled the Senior Investor Protection Act of 2008 (S.2794), which would create a new grant program to encourage state regulators to adopt a uniform standard for the accreditation of senior financial advisors, and help states’ efforts to protect seniors being mislead by these designations. The federal grants are designed to give states the ability to allocate funds for new technology, equipment and training for regulators, prosecutors and law enforcement, hiring individuals to investigate cases and provide educational materials. The legislation has been endorsed by NASAA, the American College and the Financial Planners Association.

Early Retirement Seminars

Regulators are also focusing on uncovering registered representatives who improperly advise baby boomers to retire early, cash in their company retirement plans and reinvest the funds in risky investments. In conjunction with the investigations, FINRA implemented a campaign directed at human resource directors and unions to inform these leaders and organizations of the seminars which may be enticing their employees.

In addition, FINRA has issued Investor Alerts which warn senior investors: (1) that taking earlier retirement only makes sense if they have saved enough money to begin with, (2) to make smart investment choices during their retirement years and (3) to not withdraw money at a rate which will depletetheir savings too early. While this advice may seem obvious, the number of regulatory actions against such schemes suggests many such investors - blinded by the promise of an early retirement - fail to realize that it may not be possible for them to do so.

Selling Complex Structured Products to Seniors, Particularly Collaterized Mortgage Obligations

Another ongoing regulatory investigation concerns the sale of collaterized mortgage obligations (“CMOs”) to seniors. The investigation is focusing (at least in part) on sales of principal only, interest only and inverse floater tranches of CMOs.

First, a brief primer: CMOs are sophisticated financial tools which repackage mortgages to be sold on the secondary market.[18] They are a complex type of pass-through security. A pass-through security is a device (in the form of a trust) through which mortgage payments are collected and distributed to investors. Rather than pass through interest and cash flow from a group of like-featured assets, CMOs are made up of many different pools of assets. The pools held by the CMO, called tranches, each operate according to its own set of rules by which principal and interest get distributed.[19] The difficulty in explaining these products to an arbitrator panel is palpable. Due to the complexity of these products, one would expect that there will be a lot of confused looks on the faces of panel members, confirming their belief that neither the broker nor the customer had a real understanding of the inherent risks associated with the investment.

Given the fact they are among the most complex and intricate securities, CMOs are generally reserved for sophisticated investors. Moreover, because of the current sub-prime mortgage and real estate crisis, these investments are particularly risky and subject to default. FINRA has initiated this sweep because there “appears to be a significant push to sell these complex and risky products to seniors.” [20]

Regulators are concerned that investment professionals recommend such investments to seniors without fully understanding and/or conveying the terms and risks associated. Moreover, given the complex nature of the products and their potential for risk - particularly in the current market - regulators are concerned that such products would be unsuitable for the majority of senior investors.[21]

E.Life Settlements

The regulators have also initiated a sweep concerning the sale of life settlements, also known as “senior settlements”. The concept combines an aspect of ghoulishness with a degree of financial security. A life settlement involves selling the right to receive the death benefit of an existing life insurance policy to a third party for more than the policy’s cash surrender value, but less than the net death benefit amount. The purchasers of the life settlements are generally institutions that either (1) hold the policies to maturity and collect the net death benefit or (2) resell the policies to hedge funds or other investors. In exchange for releasing the right to receive the net death benefit, the transferor receives a lump sum payment. The amount of this payment depends on age, health and the policy’s terms and conditions. Generally, the senior settlement is for some value higher than the cash surrender value, but less than the net death benefit.

While regulators do not condemn all life settlement arrangements, they do warn of their dangers. Because the practice is relatively new and targets seniors who may be in poor health, aggressive sales tactics and abuse may be involved. FINRA Notice to Members 06-38[22] reminds firms and associated persons that life settlements involving variable insurance policies are securities transactions and that firms and associated persons involved with such life settlements are subject to applicable FINRA rules.

The Notice reflects many of FINRA’s concerns with life settlements. Because the purchasers of the policies are often not subject to (or knowledgeable of) the particular duties a brokerage firm owes its clients, FINRA cautions member firms to conduct thorough due diligence of the suitability of the transaction, the disclosures made concerning the costs and risks associated with the transaction,[23] and the policies of the purchasing organization. FINRA recommends firms consider developing a list of approved life settlement providers and/or brokers whose practices are consistent with the firm’s duties to its customers.