Corporate & Securities Law

By Jim Hamilton

The SEC vigorously defended its adoption of Rule 151A defining indexed annuities as not being exempt annuity contracts under Section 3(a)(8) of the Securities Act against a federal court challenge to the rule. Relying on a series of US Supreme Court rulings, the SEC reasoned that, given the unpredictability of the securities markets, index annuities contain substantial risk that must be addressed by the disclosure regime established by the Securities Act so that investors can accurately evaluate their investment risk.

Earlier this year, the SEC adopted new rule 151A under the Securities Act in order to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. Section 3(a)(8) of the Securities Act provides an exemption for certain annuity contracts. The new rule prospectively defines indexed annuities as not being ?annuity contracts? under this exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract. The effective date of Rule 151A is January 12, 2011, two years after its adoption. Rule 151A was challenged in the US Court of Appeals for the District of Columbia Circuit. American Equity Investment Life Insurance Company v. SEC, No. 09-1021. Oral argument is set for May 8, 2009.

In its brief filed with the federal court of appeals, the SEC contended that its adoption of Rule 151A was based on a permissible construction of the term ?annuity contract? in Section 3(a)(8). The Commission explained that purchasers of indexed annuities are exposed to a significant investment risk, namely the volatility of the underlying securities index, that the securities laws were enacted to address through disclosure to investors.

Applying the Chevron framework, the Commission said that it adopted Rule 151A pursuant to its express statutory authority to adopt binding rules and regulations that define terms. Further, the interpretation of ?annuity contract? in Rule 151A is not unambiguously precluded by the statute. The Securities Act does not define ?annuity contract,? continued the SEC, and the US Supreme Court in a series of rulings has made clear that the only contracts unambiguously covered by that term are the traditional fixed annuities that existed when Section 3(a)(8) was enacted in 1933. Because indexed annuities did not exist in 1933 and confront purchasers with investment risks that traditional fixed annuities do not, said the SEC, they are not unambiguously covered by Section 3(a)(8).

Moreover, the Commission said that it reasonably concluded that indexed annuities described by Rule 151A expose purchasers to investment risk that the Securities Act was intended to address through disclosure to investors and, therefore, are not the sort of annuity that Congress intended to leave exclusively to state insurance regulation through the Section 3(a)(8) exemption. The Commission reasoned that an indexed annuity in which the payout is more likely than not to be derived from the future performance of a securities index exposes an annuity purchaser to a significant investment risk, because his or her securities-linked return is not known in advance. This determination is consistent with case law, longstanding Commission interpretations, and common understanding of investment risk.

The SEC also said that it correctly concluded that none of the asserted burdens of Rule 151A on efficiency, competition and capital formation is a basis for altering the conclusion that an indexed annuity described by the Rule is not an exempt ?annuity contract? under Section 3(a)(8). In any event, because the Commission adopted Rule 151A under its Section 19(a) authority to define terms, it was not required by the statute to analyze Rule 151A?s potential impact on efficiency, competition and capital formation.

The arguments that the Commission did not adequately address Rule 151A?s impact on small entities and that indexed annuities are not securities because they are not ?investment contracts? are not properly before the Court, noted the SEC, because they address issues not raised by any party to the proceeding. In any event, neither has merit since the Commission asserted that it adequately addressed Rule 151A?s impact on small entities; and, under settled precedent, indexed annuities are investment contracts.

The critical question addressed in the US Supreme Court opinions construing Section 3(a)(8)?s exemption is whether the contract presents investment risks that the Securities Act was enacted to address. If so, the contract is not an exempt ?annuity contract.? Rule 151A describes indexed annuities that do not qualify for the Section 3(a)(8) exemption.

Rule 151A is limited to indexed annuities that are ?more likely than not? to pay a return based on the uncertain future performance of a fluctuating index of securities such as the Standard & Poor?s 500 Index. The Commission reasonably determined that these products expose purchasers to substantial investment risk. Such risk exists for the simple reason that purchasers cannot know in advance how much money they will make in light of the inherent unpredictability of the securities market.

Full post as published by Jim Hamilton's World of Securities Regulation on April 20, 2009 (boomark / email).