The United States Court of Appeals for the District of Columbia Circuit recently ruled in the American Equity Investment Life Ins. Co. v. SEC case and remanded the controversial Rule 151A to the Securities and Exchange Commission for reconsideration. In so doing, the three-judge panel issued a reprieve to the issuers, marketers and brokers of fixed indexed annuities, but the decision was not an absolute victory for the insurance industry.
The arguments before the Court in the American Equity case centered around the Securities and Exchange Commission’s (“SEC”) final Rule 151A which proclaimed fixed indexed annuities to be securities, subject to the requirements of the Securities Act of 19331 and the regulatory oversight of the SEC beginning January 12, 2011. The immense compliance costs for the annuity industry and the associated reduction in competition for the consumer caused a coalition of annuity issuers and independent marketing organizations to challenge the SEC’s tortured reasoning behind the rule and to petition the Court of Appeals for relief. The National Association of Insurance Commissioners (“NAIC”) subsequently filed an action seeking judicial review of Rule 151A and the two actions were consolidated in the American Equity matter. Interested parties participated in the case as amici curiae, with the National Conference of Insurance Legislators, Phillip Roy Financial Services, LLC, Phillip R. Wasserman and Allianz Life Insurance Co. of North America supporting the insurance coalition and the NAIC and The Association of American Retired Persons (“AARP”), MetLife, Inc. and the North American Securities Administrators Association supporting the SEC.
An indexed annuity is a fixed annuity that earns interest or provides other contractual benefits on the basis of an equity or stock index. Indexed annuity owners are guaranteed certain levels of investment returns according to state law and despite receiving interest credits according to a formula based on a stock or equity index, the owners do not participate in any fund or portfolio of securities. Prior to the adoption of Rule 151A, state insurance commissioners had sole regulatory authority over the financial product.
The insurance industry and regulators petitioned the court to review the language of the final Rule 151A, the SEC’s rationale and the promulgation process. Specifically, Petitioners allege that the SEC’s redefinition of “annuity contract” pursuant to § 3(a)(8) of the Securities Act constituted such an abuse of discretion that the agency action was ineligible for deference under the Chevron2 doctrine. Moreover, the insurance petitioners argued to the court that the SEC’s failure to consider the “efficiency, competition and capital formation” as required by its rulemaking authority3 is sufficient to invalidate the rule.
In remanding the rule to the SEC for reconsideration, the Court found some of the arguments advanced by the petitioners to be determinative while finding other arguments to be unpersuasive. Initially, the Court rejected the industry argument that the SEC acted in such an arbitrary manner in redefining the term “annuity contract” that the agency is ineligible for deference pursuant to the Chevron v. Natural Res. Def. Council4 case. The Court cited §19(a) of the Securities Act as bestowing express authority to the SEC to define terms and make rules. Accordingly, the decision stated, the SEC was entitled to Chevron deference for review of Rule 151A and the Court undertook an analysis of the rule pursuant to Chevron.
The first prong of the two-prong Chevron test is whether the statute being interpreted is ambiguous. The United States Supreme Court decisions in VALIC5 and United Benefit6 were referenced by the Court in finding that the Securities Act is ambiguous on whether the term “annuity contract” includes all products described as annuities. The Court logically reasoned that if the term “annuity contract” was unambiguous, the extensive analysis performed by the Supreme Court in VALIC and United Benefit would not have been necessary. The petitioners argued that the VALIC and United Benefit decisions removed any ambiguity that might have existed in §3(a)(8) regarding fixed indexed annuities, specifically considering the issuer’s investment management and the state insurance regulation of indexed annuities. The Court found the petitioners’ interpretation of the cases to be too restrictive.
The second test for the SEC’s Rule 151A under Chevron was whether the rule is a reasonable interpretation of the statute. The Court implied that it might have reached a better conclusion than the SEC, but the interpretation adopted by the SEC was based in reason. The SEC’s justification that a fixed indexed annuity is more like a security than an annuity exempt under Rule 151 due to the index-based return being unknown until the end of the crediting cycle was found to be reasonable by the Court. Despite the Court finding the petitioners’ arguments concerning the SEC’s mischaracterization of investment risk to be defensible, it ultimately ruled the argument was insufficient to find the rule to be arbitrary or capricious. The Court further rejected petitioners’ arguments that the SEC failed to balance the investment risks assumed by the insurer against the investment risks assumed by the purchaser and failed to address product marketing in determining whether the contract is a security. The SEC’s actions could not be considered unreasonable by the Court, in finding Rule 151A satisfied the second prong of the Chevron analysis.
Finally, the Court addressed the SEC’s §2(b) analysis, the provision that requires for every rulemaking by the SEC, in addition to whether the action is necessary or appropriate in the public interest, “the Commission shall also consider, in addition to the protection of the investors, whether the action will promote efficiency, competition and capital formation.”7 The petitioners challenged the adequacy of the SEC’s efficiency, competition and capital formation scrutiny as incomplete. The SEC countered that a §2(b) analysis was not required for adoption of Rule 151A. The Court completely rejected the SEC’s position that a §2(b) analysis was not necessary for Rule 151A promulgation on the basis that the SEC included its interpretation of efficiency, competition and capital formation in the specific language of the rule. Accordingly, the SEC must defend its stated analysis, not claim the reasoning was unnecessary, the Court opined.
On the merits of the §2(b) analysis, the Court found the SEC’s action to be arbitrary and capricious. The Court ruled the conclusion that Rule 151A would increase competition was lacking both a reasoned basis and any finding on the existing level of competition in the marketplace. Similarly, the opinion of the Court stated the efficiency analysis was incomplete due to the SEC’s failure to consider the current regulatory regime and whether sufficient investor protections exist to enable investors to make informed decisions and producers to make suitable recommendations to consumers. The flawed efficiency analysis also resulted in the capital formation reasoning to be arbitrary and capricious. As a result, the Court remanded the rule to the SEC to address deficiencies in its §2(b) analysis.
The remand of Rule 151A may cause a momentary sigh of relief from the industry, but ultimately the fixed indexed annuity marketplace faces more uncertainty as a result of the rule’s reconsideration. Initially, the industry should celebrate the deferral of the January, 2011 effective date of Rule 151A, but the future strategy of the SEC will determine the eventual champion in the Court’s decision.
The Commission reportedly has been claiming a victory in the Court’s affirmation of the SEC’s ability to define the term “annuity contracts.” So, interested parties are cautiously waiting for the Commission’s next steps. Logically, the SEC seems to have several options. The Commission may choose to reissue the rule without an analysis on competition, efficiency and capital formation, although such a decision is surely to involve an additional challenge by the industry. The SEC may decide to reissue the rule with a complete record and §2(b) reasoning. However, such a course will involve significant resources and time to effectively address the current state regulatory system and the functioning of the existing marketplace. Any attempt at performing a less than complete analysis is surely to be challenged by the annuity industry. Further, in choosing this course of action, the SEC will be required to divert resources from other issues during a time that financial services regulation modernization is being debated by the United States Congress.
Perhaps the most effective strategy for the SEC would be to engage in an actual dialogue with the state insurance regulators to discuss legitimate consumer protection issues and perceived deficiencies in the state oversight of fixed indexed annuities. Insurance regulators have submitted documentation and testimony during the rule’s promulgation process, without recognition or response from the Commission. Very little discourse and debate among the regulators seems to have occurred. Further, very little interpretation of the data compiled by the insurance regulators and the insurance industry appears to have been conducted by the Commission. Quite possibly, the consumer enforcement issues identified by the SEC might be addressed by the state insurance regulators without the need for a duplicative regulatory regime that adds significant cost to annuity purchasers without affording any actual benefit to those same consumers.
If the dialogue indicates that states are unwilling or unable to respond to the SEC’s concerns, the Commission would at least have the advantage of the expertise and market conditions from current regulators required to be addressed in a revised Rule 151A. Regardless, such a sharing of information and coordinated effort at enhanced protections for purchasers would remove the taint of an unjustified, singularly-focused, political power grab that has enveloped Rule 151A since its adoption.
You can learn more by reading Julie McPeak’s series of blogs on SEC Rule 151.