Yesterday, the U.S. Court of Appeals for the District of Columbia Circuit issued its opinion in American Equity Investment Life Insurance Company, et al. v. Securities and Exchange Commission,1 which challenged the validity of Rule 151A under the Securities Act of 1933 (1933 Act). The court held that SEC’s interpretation of the term annuity contract, which effectively excludes fixed indexed annuities (FIAs) from the exemption in § 3(a)(8) of the 1933 Act, was reasonable. However, the court remanded Rule 151A for further analysis, of the effect of Rule 151A on efficiency, competition, and capital formation, pursuant to § 2(b) of the 1933 Act. The court found that the SEC’s consideration of Rule 151A’s effect on efficiency, competition, and capital formation was arbitrary and capricious. The decision of the three-judge panel was unanimous.
Below are some highlights of the court’s analysis of petitioners’ § 3(a)(8) arguments and the SEC’s § 2(b) analysis.
The Court’s § 3(a)(8) Analysis
- The court analyzed the SEC’s actions under Chevron’s2 two-step analysis for determining whether deference should be given to an agency interpretation of a statute: (1) whether the statute is ambiguous; and (2) whether the subject rule is a reasonable interpretation of the statute.
- The court found that step one of Chevron analysis was satisfied because the “Act is ambiguous, or at the very least silent, on whether the term ‘annuity contract’ encompasses all forms of contract that may be described as annuities.” The court noted that VALIC3 and United Benefit4 confirm this ambiguity, and that had the statute been unambiguous, “the [Supreme] Court need not have undertaken such an exhaustive inquiry in determining whether the two products at issue in those cases were annuities.”
- Petitioners argued that VALIC and United Benefit establish that an “annuity” falls outside of § 3(a)(8) only if it is subject to the insurer’s investment management, and not subject to state insurance laws. The court found that petitioners’ analysis of those cases was too narrow. Rather, according to the court, those cases indicate that the § 3(a)(8) exemption applies to products that “did not present very squarely the sort of problems that the Securities Act . . . [was] devised to deal with, and which were, in many details, subject to a form of state regulation of a sort which made the federal regulation even less relevant.” United Benefit, 387 U.S. at 210 (quoting VALIC, 359 U.S. at 750) (Brennan, J., concurring). The court noted that while an insurer’s investment management actions associated with a product may be relevant to determining whether that product is an annuity, “this is not the only relevant characteristic.” Further, the court noted that the Supreme Court recognized in United Benefit that VALIC had “conclusively rejected” the notion that adequate state regulation was a sufficient basis for qualifying for the § 3(a)(8) exemption.
- In analyzing the second step of the Chevron analysis, the court noted that it is “irrelevant that this court might have reached a different—or better—conclusion than the SEC.” To meet Chevron, Rule 151A only must be reasonable.
- The court noted that as with securities, indexed annuities present a “variability in the potential return that results in a risk to the purchaser.” By contrast, “an annuity within § 3(a)(8) avoids this variability by guaranteeing the interest rate ahead of time.”
- Petitioners argued that the SEC based its analysis of Rule 151A on an “insupportable definition of investment risk.” The court noted that in petitioners’ view, investment risk exists only where the purchaser of a security faces the possibility of loss of principal. While the court noted that petitioners’ view is certainly defensible, it found that it was not sufficient to establish that Rule 151A is arbitrary and capricious.
- The court stated that the SEC has always been consistent in its position on investment risk. The court cited Rule 151 and its adopting release, where the SEC noted that it was allowing products involving investment indices to qualify for the Rule 151 safe harbor only as long as such interest rates were calculated prospectively, not retroactively.
- The court rejected petitioners’ argument that the SEC failed to balance the investment risks assumed by the insurer against those assumed by the purchaser. The court stated that petitioners’ argument “misses the mark” in part because Rule 151A “appears to be the SEC’s means of ensuring greater protection for consumers exposed to greater risk when insurers are exposed to less risk than normal,” and that “FIAs left a more than minimal risk upon the purchaser.”
- Petitioners also argued that the SEC failed to account for marketing in considering whether a product is a security. The court noted that while that argument raises a “closer issue,” it does not demonstrate that SEC’s adoption of Rule 151A is unreasonable. The court noted that the Supreme Court never held in either VALIC or United Benefit that marketing was an essential characteristic in assessing whether a product was within the § 3(a)(8) exemption. Rather, the Supreme Court focused on whether the product exhibited considerations of investment not present in a conventional insurance contract. The court noted that although marketing was considered in United Benefit, it did not establish that the SEC must undertake a marketing analysis to make a § 3(a)(8) determination. The court also noted that the SEC did consider marketing, and ultimately determined that the inclusion of that factor was not necessary. Given that indexed annuities offer a greater rate of return based on the return of an index, the court asserted that indexed annuities are more like securities from a risk perspective than they are like other annuity contracts. As such, according to the court, it is reasonable to assume (as did the SEC when it stated that to do otherwise would be potentially misleading) that any marketing of the product would be securities-related.
The § 2(b) Analysis
- Section 2(b) of the 1933 Act requires that the SEC consider whether a rulemaking will “promote efficiency, competition, and capital formation.” Petitioners argued that the SEC failed to properly consider the burdensome costs of additional regulation and to assess the existence of abuses of indexed annuities before applying securities regulations to the issuers of indexed annuities. The court found that the SEC’s § 2(b) analysis was deficient with respect to all three factors.
- The court rejected the SEC’s argument that it was not required to conduct a § 2(b) analysis. The SEC argued that § 2(b) by its terms only requires that analysis when a provision of the 1933 Act requires the SEC “to consider or determine whether an action is necessary or appropriate in the public interest” and that Rule 151A was adopted pursuant to § 19(a),5 which does not contain the statutory predicate set by § 2(b). However, the court noted that the SEC did conduct a § 2(b) analysis and therefore must defend that analysis before the court. But at the conclusion of its opinion, the court said that on remand, the SEC must either satisfy its obligations under § 2(b) “or explain why that section does not govern this rulemaking.”
- The SEC claimed that Rule 151A will increase competition because it will bring “clarity.” This clarity, according to the SEC, will encourage issuers to enter the market and registered broker-dealers to sell indexed annuities. The court rejected this argument and noted that any rule will bring clarity. The court said that § 2(b) does not ask for an analysis of whether any rule would have an effect on competition, but rather requires an analysis of whether the specific rule will promote efficiency, competition, and capital formation.
- The court found that the SEC’s finding on competition also failed because the SEC did not make any finding on the existing level of competition in the marketplace under the state law regime. The court rejected the SEC’s argument that by making a detailed § 2(b) analysis about state law, the SEC would contravene United Benefit and VALIC. The court noted that the SEC’s obligations under § 2(b) are distinct from the questions posed in United Benefit and VALIC.
- The SEC argued that Rule 151A would promote efficiency because the required disclosures under the rule would enable investors to make more informed investment decisions and would enable sellers to make more suitable recommendations. The court found that the SEC’s efficiency analysis was arbitrary and capricious because the SEC failed to analyze the efficiency of the existing state law regime.
- Because of the flawed efficiency analysis, the court found that the SEC’s capital formation analysis was arbitrary and capricious.
- In its remand to the SEC to address the deficiencies with its § 2(b) analysis, the court noted that it “is obvious that the SEC believes imposing a federal framework on FIAs would be superior to the existing patchwork of state insurance laws,” and that the SEC “may decide ultimately that Rule 151A will promote competition, efficiency, and capital formation.”