Securities

SEC Faces Active Questioning From Judges
In Oral Argument to Defend Annuities Rule

In oral argument before the U.S. Court of Appeals for the District of Columbia Circuit, a Securities and Exchange Commission attorney May 8 faced a barrage of questions from the three-judge panel over the commission's decision to regulate equity-indexed annuities based on the products' investment risk (American Equity Investment Life Insur. Co. v. SEC, D.C. Cir., No. 09-1021, 5/8/09).

SEC Senior Special Counsel Michael Conley represented the agency in a case brought by a group of insurance companies challenging the SEC's authority to promulgate 1933 Securities Act Rule 151A. Among other measures, the rule clarifies when equity-indexed annuities may be regulated under federal securities laws. The SEC adopted the rule in a 4-1 vote in December, despite strong opposition from state insurance regulators and the insurance industry (243 DER A-36, 12/18/08). The agency's rulemaking has tremendous ramifications for the insurance industry, which faces added expenses amounting to millions of dollars. The SEC itself has estimated that the costs of compliance for the industry could reach over $100 million in the first year alone. Recognizing its significance, the D.C. Circuit agreed to hear the case on an expedited basis.

‘Hybrid' Indexed Annuities

The products regulated by Rule 151A are a complex class of insurance annuities whose returns are tied to the performance of a securities index, such as the Dow Jones Industrial average. When an investor decides to take his money out, the timing of the decision, the terms of the contract, and the performance of the index determine whether the investor's pay-out is more or less than the money contributed in the first place. It also is extremely difficult to compare one equity-indexed annuity to another because there are so many different features among various products.

A significant factor in the SEC's case is that equity-indexed annuities present investment risks that the 1933 Act was enacted to address. At the oral argument, Conley told the panel—comprising Chief Judge David Sentelle, and Judges Douglas Ginsburg and Judith Rogers—that the products present substantial investment risks because of their “uncertainty of returns.” Purchasers do not know in advance how much they will make, or even whether they should stay in the contracts, he said. “The critical point is whether you have all the information you need to make an informed decision.”

Questions on Risk

Ginsburg observed that even lottery tickets come with substantial uncertainty of returns, although he added that he was not suggesting that the SEC should regulate lottery tickets. For his part, Sentelle noted that all annuities come with some measure of risk. In response to the judges' rigorous questioning, Conley acknowledged that equity-indexed annuities come with a guaranteed minimum value. Any risks associated with the products are over and above the minimum guarantee, he said.

The SEC attorney also told the panel that annuities involve a wide spectrum of products ranging from fixed annuities—which are clearly insurance products—to variable annuities, which are clearly securities. In between is a “grey area” of hybrid products, including equity-indexed annuities, which have the characteristics of both insurance and securities. Because indexed annuities are not unambiguously covered by the exemption from registration under 1933 Act Section 3(a)(8), the SEC's reasonable interpretation that the products are securities should receive deference, Conley said.

SEC Said to Employ Incorrect Risk Theory

Arguing on behalf of the industry petitioners, Eugene Scalia of Gibson Dunn & Crutcher LLP, Washington, said that the SEC was encroaching on a traditional state area, and had ignored states' comprehensive regulation of the products. The commission, by imposing additional requirements to the already extensive state regulatory regimes, would substantially increase costs for the industry, he said.

Scalia also faced active questioning from the judges. Rogers wanted the attorney to explain what the SEC failed to do in its rulemaking. The attorney answered that the agency failed to base Rule 151A on the “reality” of annuities; instead, “this rule is based on theories.” Sentelle asked whether it was the commission's job to analyze the risks associated with the products, and to do rulemaking based on its analysis. In response, Scalia said that this was an “unusual area.” “The economic theories that they identify have to be consistent with reality,” he continued. Scalia said that the SEC's theory regarding the investment risks for indexed annuities “simply is incorrect.” Also, he said, it is the insurers who bear most of the risks for the products.

States' Back Industry Position

In addition, Scalia pointed to a comment letter by the American Academy of Actuaries—which he noted are experts on the subject—that said equity-indexed annuities were more akin to traditional annuities than securities. The Sept. 10, 2008, comment was sent in response to the agency's rulemaking proposal.

Rodney Page of Bryan Cave LLP, Washington, argued on behalf of amicus the National Conference of Insurance Legislators, who filed in support of the industry petitioners. Page told the judges that the SEC's rulemaking was in “complete disregard” for an existing and robust state regulatory regime for indexed annuities. “This rule is a solution in search of a problem,” he said.

By Yin Wilczek