On May 8, 2009, a three-judge panel1 of the U.S. Court of Appeals for the District of Columbia Circuit heard oral argument in the case of American Equity Investment Life Insurance Company, et al., v. Securities and Exchange Commission (“American Equity” or the “case”), which challenged the validity of Rule 151A under the Securities Act of 1933 (the “1933 Act”). The Securities and Exchange Commission (“SEC”) adopted Rule 151A in December 2008, and the Rule was published as a final release in January 2009.2
American Equity represents the consolidation of two cases in which each petitioner sought to have Rule 151A vacated3 – one case was brought by industry petitioners,4 and the other case was brought by the National Association of Insurance Commissioners (the “NAIC”).5 The court heard arguments from the industry petitioners, the NAIC and the SEC.
Many of the points set forth in the parties’ briefs were touched upon in the oral argument. Selected briefs of the parties are attached.6
Members of the panel asked numerous questions of industry petitioners and of the SEC that caused industry petitioners and the SEC to exceed the time allotted for argument. The panel members’ questions went both to the substance of the Rule and to the procedures through which it had been adopted. The major issues raised during the argument focused on state regulation, deference, investment risk, and procedural arguments.
Major Issues Raised During the Oral Arguments
i. State Regulation
Both industry petitioners and the NAIC argued that Rule 151A should be vacated because the Rule is an impermissible encroachment on state regulation.7 They focused on the U.S. Supreme Court statements in VALIC8 that there should be a reluctance to disturb the state regulatory regime. Industry petitioners and the NAIC argued that while state schemes are not dispositive, the SEC erred in effectively determining that the nature and the extent of state regulation were irrelevant. They argued that state regulation of insurance should be evaluated in light of the current marketplace – more specifically, that the SEC incorrectly interpreted the Supreme Court’s analysis in VALIC insofar as the SEC’s rationale supporting Rule 151A assumed that both the concept of insurance and the nature and extent of state regulation were frozen and did not evolve over time.
The SEC argued that the state laws in this area are not uniform and comprehensive, and that state law generally is not relevant here because the interpretation of “annuity” in Section 3(a)(8) is a federal question. The SEC contended that the issues raised by industry petitioners and the NAIC were resolved by the Court in VALIC.9
Members of the panel questioned whether the Rule, if upheld, would, in fact, interfere with state regulation of insurance. It was observed that the imposition of additional costs is not really interference, but industry petitioners did assert that the SEC/FINRA regulatory framework would in fact override and be inconsistent with, certain state regulatory requirements. The SEC noted that the states would still have concurrent authority over the products.10
Industry petitioners argued that the Section 3(a)(8) exemption from registration under the federal securities laws of the 1933 Act clearly encompasses all fixed annuities that are subject to the full panoply of state regulation (including, but not limited to, non-forfeiture regulation), and that under the Chevron doctrine11 the Court is not obligated to defer to the SEC’s interpretation of U.S. Supreme Court precedents (here, the VALIC and United Benefit cases12) dealing with the scope of Section 3(a)(8).
The SEC asserted that because the term “annuity” in Section 3(a)(8) is ambiguous, Chevron deference is due when, as here, the agency’s interpretation is reasonable. The SEC noted that there is a spectrum of annuity products with traditional fixed annuities (which clearly are not securities) on one end and variable annuities (which clearly are securities) on the other end. In between those two extremes are “hybrid” products to which the application of Section 3(a)(8) is ambiguous. It further noted that there has been a half century of SEC and judicial interpretations analyzing the Section 3(a)(8) status of fixed annuities with excess interest features and principal guarantees, all of which involved whether, and if so, when an excess interest mechanism could turn the instrument into a security.
iii. Investment Risk
Industry petitioners argued that the SEC’s theory of investment risk was flawed. They asserted that the SEC failed adequately to take into account the investment risks borne by insurers and that the investment risk borne by purchasers under fixed indexed annuities was indistinguishable from the risks purchasers bear in connection with traditional fixed annuities because, like fixed indexed annuities, traditional fixed annuities have prospective year-to-year uncertainty. They claimed that the SEC erred by acknowledging the expertise of the American Academy of Actuaries, yet ignoring the Academy’s analysis of investment risk in its comment letter on the Rule. (The Academy concluded that the investment risk assumed by an insurer under a fixed indexed annuity was similar to the risk in a traditional fixed annuity because the insurer pre-commits to paying indexed interest, unlike a variable annuity.)
Judge Rogers inquired why the U.S. Supreme Court’s functional approach to investment risk was not applicable here, asking why the SEC’s analysis of the nature of investment risk should not stand. Industry petitioners responded, in part, by stating that the SEC failed to consider “reality” in its rulemaking analysis.
There was significant discussion of the retrospective nature of the investment risk in indexed annuities, with questions raised about the importance of the risk of uncertain future returns in the context of a product designed and meant for long-term investment.13
With regard to the Rule’s focus on the risk of excess interest, the SEC pointed out that every case decided since United Benefit has dealt with the uncertainty of payment of interest beyond the minimum. The SEC also noted that the Academy’s comment letter focused on the similarity of how an insurer hedges its risk for its traditional fixed and fixed indexed products, and not on the purchaser’s investment risk.
iv. Procedural Arguments
Judge Ginsburg criticized the SEC for arguing in the Adopting Release that resolving the uncertainty of the securities status of indexed annuities was an analysis of the Rule’s effect on competition and capital formation, as required by Section 2(b) of the 1933 Act. Judge Ginsburg noted that the SEC was providing a legal response to a statutory requirement for an economic analysis. He strongly hinted that an insufficient Section 2(b) analysis in the Adopting Release could result in a remand of the Rule to the SEC for further analysis.
There was a discussion about whether, if the Rule is not upheld, it should be vacated or remanded. Industry petitioners emphasized that they are asking that the Rule be vacated in its entirety, not remanded for additional analysis. When asked whether a remand would be appropriate if the Adopting Release’s analysis of the Rule’s effect on competition were found to be flawed, the SEC responded that a remand would be appropriate in that circumstance.
Industry petitioners noted that the case could help resolve a split between the Seventh and Tenth Circuits. According to industry petitioners, the SEC relied heavily on the court’s opinion in Associates in Adolescent Psychiatry, S.C. v. Home Life Insurance Company, 941 F.2d 561 (7th Cir. 1991) where the court determined that the contract at issue was an “annuity” within the meaning of Section 3(a)(8) because, in part, the insurer set the excess rate at the start of the year. However, industry petitioners noted that in Olpin v. Ideal National Insurance Company, 419 F.2d. 1250 (10th Cir. 1969) (“Olpin”), the court determined that establishing a crediting formula in advance, even if actual interest was determined at the end of period, was sufficient for the court to conclude that a bonus fund endorsement to life insurance policies was not a security. Therefore, industry petitioners argued that upholding the Rule would create a conflict between the D.C. Circuit and the 10th Circuit’s Olpin decision.
Because the Court has granted expedited treatment of this case for purposes of briefing and argument, we would expect a decision within the next few months, likely sometime before September.