The Securities and Exchange Commission (the “SEC”) recently charged a life insurance company with violating the pricing requirements under Rule 22c-1 of the Investment Company Act of 1940 in respect of purchase and redemption orders for variable insurance contracts, and the underlying mutual fund investment options.1 Under Rule 22c-1, the price at which an order is executed must be based on the net asset value (“NAV”) of the security that is next computed after receipt of the order. According to the SEC order instituting a settled administrative proceeding against the company, from October 1995 through September 2011, the company’s mail-processing practices caused purchase and redemption orders received through regular U.S. mail to be purposefully delayed before reaching the company’s processing center, resulting in the current day’s transaction requests being assigned the next business day’s price.
Background
The company’s variable contract prospectuses disclosed that orders received at the company’s home office before 4 p.m. would receive the current day's accumulation unit value ("AUV"), the equivalent to NAV for variable insurance contracts. Prospectuses of underlying mutual funds offered as investment options under the contracts similarly disclosed that orders received before 4 p.m. would be assigned the current day's NAV.
According to the SEC’s order, customer mail relating to the company’s variable insurance contracts was transmitted to the company through a variety of methods (e.g., U.S. First Class Mail, U.S. Priority Mail, electronic orders, telephone request and facsimile), and delivered to post office boxes maintained by the company at a central U.S. Postal Service post office, as well as to the company’s home office. The company hired couriers to retrieve mail from the post office several times a day, with the first trip occurring at 3 a.m. The order alleges that the company arranged for the postal service to segregate the mail relating to the variable insurance contracts from all other mail, and although the variable insurance contracts mail generally was available for pick-up by 10 a.m. each morning, the company instructed its couriers not to retrieve the variable insurance contracts mail until after 3 p.m. each day. The order further alleges that the company instructed the couriers who retrieved the variable insurance contracts mail not to enter the home office building until 4:01 p.m., with the result being that orders from this mail run were marked with a post-4 p.m. time stamp, processed for pricing at the next day's AUV (instead of the current day’s AUV), and then transmitted to the underlying mutual funds for pricing, also at the next day’s NAV. The SEC’s order notes that, in contrast, Priority Mail, which is trackable by the sender, was picked up from the post office by the company’s courier at 10 a.m. each day, delivered to the home office generally no later than 11 a.m., and processed by the company before 4 p.m. at the current day’s AUV.
Violation and Sanctions
The order finds that, as a result of the conduct summarized above, the company willfully violated Rule 22c-1. As noted in the order, in determining to accept the settlement offer of the company, the SEC considered the remedial acts promptly undertaken by the company and the cooperation afforded to the SEC staff. The order requires the company to cease and desist from committing or causing any violations and any future violations of Rule 22c-1, and to pay a civil money penalty of $8 million.
Observations
Given the complexity of variable insurance products and the volume of transaction requests typically received by large variable contract issuers, order processing pressures for those securities can become acute from time to time and may bear negative financial consequences. For example, processing backlogs can lead to “as of” pricing, which in turn can lead to sometimes-significant “breakage” losses to the insurer. However, given the significant penalties the insurer had to pay in the instant case, insurers with significant variable contract operations may want to review their processing and other procedures to determine if additional resources or other types of corrective measures should be instituted to ensure compliance with applicable pricing requirements under the Investment Company Act of 1940.
- In the Matter of Nationwide Life Insurance Company, Investment Company Act Release No. 31601 (May 14, 2015).
Client Alert 2015-144