Securities Issues

Are equity-indexed annuities considered securities? Usually they are not, but they can be in some circumstances. It all depends on whether they qualify for what is known as the Rule 151 Safe Harbor, which requires compliance with three primary elements:

(1) The equity-indexed annuity contract is subject to supervision by the state insurance commissioner;

(2) The insurer assumes the investment risk under the contract; and

(3) The Contract is not marketed primarily as an investment.

It is the last element that insurance agents who sell EIAs are most likely to violate. For instance, if an EIA is sold to a very elderly person, because of their life expectancy the only straight-faced reason that could be given for the EIA sale was that it was an investment by the elderly buyer. However, if it is sold for this purpose, it may fall out of the Rule 151 Safe Harbor and thus require registration as a security.

As of this writing, the SEC is revisiting (at the request of the NASD) whether equity-indexed annuities should be considered securities, and thus sold only by broker-dealers and subject to suitability requirements and registration as securities.

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Malone v. Addison Ins. Mktg. Inc., 225 F. Supp. 2d 743 (W.D.Ky 2002)

UNITED STATES DISTRICT COURT FOR THE WESTERN DISTRICT OF KENTUCKY, LOUISVILLE DIVISION

BEVERLY S. MALONE, PLAINTIFF v. ADDISON INSURANCE MARKETING, INC., et al., DEFENDANTS

CIVIL ACTION NO. 3:01-CV-259(H)

September 30, 2002, Decided -- September 30, 2002, Opinion Filed

COUNSEL: [List of counsel in the case omitted]

JUDGES: JOHN G. HEYBURN II, CHIEF JUDGE, U.S. DISTRICT COURT.

OPINIONBY: JOHN G. HEYBURN II

OPINION: MEMORANDUM OPINION

Plaintiff, a 73-year old widow and Kentucky resident, brought this class action under the Securities and Exchange Act of 1934 to recover for the harm caused to her and members of the class by Defendants' fraudulent sale of living trusts and other investments. [Footnote 1 omitted] Defendants are seven corporations and seven individuals who sold Plaintiff these products as well as provided her with legal, investment, and insurance advice. [Footnote 2 omitted] The Court appointed Malone as the Lead Plaintiff, but has yet to certify a class of plaintiffs. All Defendants have now moved to dismiss the complaint pursuant to Rule 12(b)(6).

I.

Plaintiff charges an intricate scheme to wrongfully market living trusts, annuities, and other securities. Because Plaintiff's complaint details a lengthy pattern, the facts in this case are best described in four phases: (1) the sale of the living trusts, (2) the transfer of Plaintiff's stocks to a new broker, (3) Plaintiff's decision to purchase two annuity contracts, and (4) Plaintiff's decisions to transfer her remaining assets to new brokerage firms and sell two life insurance policies. However, the Court's analysis of Plaintiff's claims solely concerns the sale of annuity contracts.

In 1999, Defendant Victor E. Tackett, a practicing attorney admitted to the Kentucky bar mailed out to senior citizens, a letter advertisement entitled "How to Avoid Probate" which discussed the advantages of forming a living trust. Defendant Joel Miller is an employee of Defendant ALMS, serves as a client service representative for Tackett, and is a registered agent for Defendant American Equity. After Plaintiff responded to one of Tackett's advertisements, Miller, acting on behalf of Tackett, met the Plaintiff and her husband at their home. During that meeting, Miller counseled the couple to purchase a living trust and collected detailed financial information. Based on Defendants' advice, Plaintiff paid Tackett $ 1995.00 to setup and administer her living trust. Following this sale, Plaintiff received a package of materials labeled from the "Law Office of Victor E. Tackett, Jr."

Next, Plaintiff's Complaint alleges that, "in furtherance of Defendants' scheme and course of conduct," Defendant Terry J. Ciotti met with the Plaintiff on multiple occasions. Ciotti is licenced under the Kentucky Department of Insurance to sell [*746] life insurance and has been an agent for American Equity, Addison insurance Marketing, Inc., and Midland Life Insurance Company. At the first meeting, Ciotti reviewed a Tackett brochure and circled the advantages of a living trust. In the course of her meetings with Ciotti and Miller, Plaintiff says she was falsely mislead into believing a living trust was in her best financial interest when, in fact, it proved to be financially devastating. Ciotti delivered the trust documents to Plaintiff around early October of 1999.

In the second phase of the scheme, Plaintiff's complaint alleges that Ciotti advised Plaintiff to transfer her stock portfolio to Defendant Sidney Mondschein "who could do a better job managing the portfolio." At the time, Mondschein was a broker employed by the Defendant security brokerage firms Financial West Group, Sentra Securities, and Williams Financial. While at Plaintiff's home, Ciotti called Mondschein who spoke with the Plaintiff and assured her he would take good care of her assets. On the advice of Ciotti and believing him to be a representative of Tackett, Plaintiff's complaint states that she "signed other documents allowing Ciotti to 'sweep' her investment account and all of its assets."

Plaintiff claims that Ciotti then pressured her "into surrendering an equitable annuity and placing money from that annuity in Ciotti's control." Additionally, she alleges that Defendants engaged in "churning" whereby they bought and sold in rapid succession dividends from her existing life insurance policies or annuities to purchase replacement policies. Defendants explained that these new polices provided greater death benefits, cash values and surrender values although they charged her exorbitant commissions and other administrative charges, costing Plaintiff thousands of dollars.

In phase three, Plaintiff alleges that Ciotti, acting as a licensed agent of American Equity, helped Plaintiff purchase two annuities from American Equity. Plaintiff purchased the first annuity contract, dated September 23, 1999, for a lump sum premium of $ 64,214.32. She designated her children as the intended beneficiaries of this annuity. On October 27, 1999, Plaintiff purchased her second annuity contract for a lump sum premium of $ 216,289.53. [Footnote 3 omitted] The intended beneficiary of this second annuity was "The Dr. Harold G. Malone and Beverly S. Malone Revocable Living Trust." It is these two annuities which Plaintiff claims are securities and which, therefore, become the focus of the motion to dismiss.

According to the annuity contract, Plaintiff purchased an American Equity product known as "The Ultimate Equity Index." The contracts state that the Ultimate Equity Index is a single-premium deferred annuity. In effect, the Index operated as an insurance plan with an investment aspect through which Plaintiff purchased a contract backed by American Equity. Under the contract terms, American Equity guaranteed Plaintiff a minimum return of 100 percent of her premium plus at least 3 percent interest annually, depending on how the S&P 500 Index fared. Specifically, American Equity agreed to pay Plaintiff an annual interest credit based on a formula tied to the performance of the S&P 500 Index during the contract year. American Equity promised Plaintiff she would always get at least a 3 percent return annually and was guaranteed more if the S&P 500 Index produced a higher rate of return. This amounted to a guarantee of 134 percent of her premium at the end of her ten-year contract term.

In phase four, the complaint alleges that the remains of Plaintiff's assets went in two directions. First, on the advice of Ciotti and other unspecified Defendants, Plaintiff transferred the remainder of her money to Financial West, a California brokerage firm which employed Mondschein. Thereafter, Mondschein advised Plaintiff to move her account to two additional brokerage houses, Sentra and Williams Financial. Second, Plaintiff alleges that in furtherance of Defendants' scheme, Defendant Van Meter, Defendant ALMs, and the other Defendants advised Plaintiff and her husband to cash in two life insurance policies. The life insurance policies had a face value of $ 100,000, but a cash out value of less than $ 10,000. Plaintiff followed this advice.

In all, Plaintiff's complaint asserts two federal causes of action and eight state law claims. The first count, asserted against twelve of the defendants, [Footnote 4 omitted] alleges that Defendants violated Section 10(b) of the Securities and Exchange Act and Rule 10b-5 by making false and misleading representations of material facts both in person and through instrumentalities of interstate commerce. The second count alleges that Noble, McIntyre, and Tackett violated Section 20(a) of the Exchange Act by serving as "controlling persons" of the Defendant corporations.

II.

On a motion pursuant to Rule 12(b)(6), dismissal of the complaint is proper only if it is clear that the plaintiff can prove no set of facts in support of her claim which would entitle her to relief. See Mayer v. Mylod, 988 F.2d 635, 638 (6th Cir. 1993). Counts I and II of Plaintiff's Complaint are grounded in the Securities and Exchange Act of 1934. The threshold question in any action brought pursuant to the Securities Acts is whether a "security" exists. Union Planters Nat'l Bank of Memphis v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174, 1179 (6th Cir. 1981). To meet this threshold, Plaintiff claims that the annuity contracts she purchased from American Equity were securities. [Footnote 5] This case therefore requires the Court to decide whether a fixed indexed deferred annuity is a "security" within the meaning of the 1934 Act. Neither side has identified any disputed material fact which might prevent the Court from resolving this discreet issue.

 [Footnote 5] In her reply brief, Plaintiff also conclusively states that the issue of whether annuities constitute securities does not need to be analyzed because "Plaintiff has alleged that the stocks she sold at Defendants' urging in order to finance her purchases of Defendants' annuity contracts and other securities are obviously securities invoking the Exchange Act." In her complaint, however, plaintiff only makes mention of these other stocks on two occasions, neither of which are sufficient to allege a violation of the Exchange Act. First, she alleges that, under pressure from Ciotti, she allowed Mondschein to assume control of her portfolio. Second, she alleges that, under advice from Tackett, she "signed other documents allowing Ciotti to 'sweep' her investment account and all of its assets, which Ciotti promptly did in furtherance of Defendants' scheme and course of conduct in his capacity as Defendant Tackett's estate planning representative."

[Footnote 5 continued] Neither of these overly conclusive allegations can form the basis for a claim under the Exchange Act. In both cases, the fraud alleged did not involve the sale or purchase of a security, but rather the management of a portfolio. See Klorer v. Bennett, 1990 U.S. App. LEXIS 11591, *19 (6th Cir. 1990) (noting that "Section 10(b)'s fundamental purpose is to assure that full information is available to decision makers in security transactions" thus protection "of those who have entrusted the decision making to others is a concern of state law, for which a cause of action under § 10(b) should not be inferred"). If anything, Plaintiff's Complaint indicates that she transferred all authority to make investments to Mondschein and Ciotti; Plaintiff herself made no investment decisions. Therefore she was not the actual purchaser or seller of securities and can not bring an action against "Defendants" for these transactions because her claim is not covered by the Exchange Act.

The text of the 1934 Act coupled with the SEC's Safe Harbor provision provide the Court with two guideposts in making this determination. First, the Court must determine whether those annuity contracts constitute a "security" within the meaning of Section 3(a)(10) of the Securities Exchange Act, 15 U.S.C. § 78C(a)(10). Second, if the annuities are potentially a "security," the Court must analyze whether the Safe Harbor of Rule 10b-5 exempts certain types of annuity contracts from the provisions of the federal securities laws.

A.

The boundaries for determining whether an annuity contract constitutes a security within the meaning of Section 3(a)(10) are controlled by two points of law. First, Section 3(a)(8) of the Securities Act exempts from its provisions "any insurance or endowment policy or annuity contract or optional contract issued by a corporation subject to supervision of the appropriate insurance regulatory of any state." 15 U.S.C. § 77c(a)(8) (emphasis added). Second, however, in interpreting the definition of "security" within Section 3(a)(10), the Supreme Court has distinguished among different classes of annuities based on the characteristics that make them operate like securities and has classified "variable annuities" as securities, thus cutting back on Section 3(a)(8)'s sweeping exclusion. SEC v. Variable Annuity Life Insur. Co. ("VALIC"), 359 U.S. 65, 71-72, 3 L. Ed. 2d 640, 79 S. Ct. 618 (1959). The Court's inquiry therefore starts by determining whether the contract here operates more like a variable or fixed annuity.

In making its determination, the Court has carefully considered the general principles set out by the Supreme Court. As Plaintiff correctly notes, the definition of the statutory term "security" embodies "a flexible rather than static principle, one that is capable of adaptation to meet the countless and variable scheme devised by those who seek the use of the money of others on the promise of profits." SEC v. W.J. Howey, 328 U.S. 293, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946). In addition, the Supreme Court has said that, in searching for content in the term "security," "form should be disregarded for substance and the emphasis should be on economic reality." Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967). In short, though Defendants have attempted to take the easiest analytical approach, the Court cannot dispositively classify this annuity as "fixed" and thus exempt it from the reach of the Securities Act, simply because the contract itself labels it so.

The modern day differences between fixed and variable annuities are not always immediately apparent in the context of indexed deferred annuities, such as this one, where the purchaser is guaranteed a fixed payment at a later date subject to an increase based on a stock index. [Footnote 6] Each analysis in this area therefore requires the Court's particular attention to the instrument at issue. The Court begins by discussing the relevant characteristics of fixed and variable annuities and then classifies the contract on the basis of the criteria applied by the Supreme Court and other circuits.

[Footnote 6] On multiple occasions the Supreme Court has noted that the differences between the two traditional forms of annuities are often overshadowed by their similarities. See S.E.C. v. VALIC, 359 U.S. 65, 3 L. Ed. 2d 640, 79 S. Ct. 618 (1959) ("In some respects the variable annuity has the characteristics of the fixed and conventional annuity: payments are made periodically; they continue until the annuitant's death or in case other options are chosen, until the end of a fixed term ... payments are made both from principal and income; and the amounts vary according to the age and sex of the annuitant"); Nationsbank of North Carolina v. Variable Annuity Life Ins. Co., 513 U.S. 251, 264, 130 L. Ed. 2d 740, 115 S. Ct. 810 (1995) (upholding the decision of the Comptroller of Currency under the Chevron doctrine to classify all annuities, both fixed and variable, as investments rather than insurance because "though fixed annuities more closely resemble insurance than do variable annuities, fixed annuities too have significant investment features and are functionally similar to debt instruments").

The Supreme Court provided the leading discussion on this subject in a pair of cases that distinguished between variable and fixed annuities. VALIC, 359 U.S. at 69-70; SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 207-08, 18 L. Ed. 2d 673, 87 S. Ct. 1557 (1967). In VALIC, the Supreme Court explained that a chief characteristic of a variable annuity was the direct correlation between investments and pay outs to the annuitant. The Court explained that, in a variable annuity, "benefit payments vary with the success of the investment policy." 359 U.S. at 69. A variable annuitant thus assumes a much greater risk than the holder of a fixed annuity who is provided with a guarantee. "The holder of a variable annuity cannot look forward to a fixed monthly or yearly amount ... it may be greater or less depending on the wisdom of the investment policy." Id. at 70. It was this risk-bearing feature of the variable annuity that the Court found most persuasive in its decision to classify the annuity at issue as one covered by federal security laws. "In hard reality the issuer of a variable annuity that has no element of a fixed return assumes no true risk in the insurance sense." Id. at 71. In contrast, the Court concluded, the risk would at the very least be shared in a fixed annuity where there was a "guarantee that at least some fraction of the benefits will be payable in fixed amounts." Id. at 72.

Several years later, in United Benefit, 387 U.S. at 209, the Court clarified its VALIC opinion, holding that the legal analysis of whether a deferred annuity constituted a security should proceed in two parts if there was direct investment of the principal during the accumulation phase coupled with a minimum guaranteed payout at the end of the contract term. [Footnote 7] The Court held that, during the accumulation stage, the annuity in its case fell within the purview of the Exchange Act because the investor bore the burden. Id. at 208. Central to the Court's analysis was the fact that the insurer merely promised to serve as an investment agency and did not promise the policyholder a fixed amount of his savings plus interests. Id. The policyholder was thus only guaranteed either his share of the total fund into which his payments were invested, or a cash value measured by a percentage of his net premiums which only reached 100 percent after 10 years. Id.

[Footnote 7] In United Benefit, the "Flexible Fund Annuity" at issue was a deferred annuity policy under which the policyholder agreed to pay United Benefit monthly premiums for a specified period which United Benefit then maintained in a separate account. SEC v. United Benefit Life Ins. Co., 123 U.S. App. D.C. 305, 359 F.2d 619, 621 (D.C. Cir. 1966). Importantly, United Benefit did not promise to accumulate net premiums at a specified rate of interest. Rather, the company promised that the annuitant would be credited with a proportionate share of the profits which resulted from the investment and reinvestment of that money in the Flexible Fund. At the end of the contract period, the investor was guaranteed 100 percent of their initial investment if the Fund was unprofitable.

The United Benefit Court contrasted the accumulation phase of the annuity in its case with a more conventional annuity. The Court explained, where there is a fixing of the benefits stipulated at the outset in a conventional annuity, the critical issue from an investment standpoint is the planning problem shouldered by the insurer who must make the financial decisions to backup its guarantee. 387 U.S. at 208. Simply put, in a fixed annuity, "the policyholder has no direct interest in the fund and the insurer has a dollar target to meet." Id. Thus, the Court concluded, in a fixed annuity "the insurer is acting in a role similar to that of a savings institution, and state regulation is adjusted to this role." Id.

More recently, both the Second and the Seventh Circuits provided additional guidance in drawing the line between fixed and variable annuities. Lander v. Hartford Life and Ins. Co., 251 F.3d 101 (2nd Cir. 2001) (holding that variable annuity contracts constituted "covered securities" as defined by the Securities Litigation Uniform Standards Act of 1998); Otto v. Variable Annuity Life Ins. Co., 814 F.2d 1127, 1131 (7th Cir. 1986), cert. denied, 486 U.S. 1026, 100 L. Ed. 2d 235, 108 S. Ct. 2004 (1988) (affirming a grant of summary judgment where the annuity at issue was found to be an insurance product exempt from securities regulation). In Lander, the Second Circuit emphasized the extent to which the payout made by a variable annuity was entirely dependant on the success of the investment securities selected by the annuitant. 251 F.3d at 104-05. Similarly, in Otto, the Seventh Circuit found the insurance instrument at issue was clearly a fixed annuity because the company selling the product was required to pay a guaranteed rate of 4 percent interest on all fixed annuity contributions made during the first ten years of the contract. 814 F.2d at 1131-32.

Plaintiff's effort, therefore, to classify her American Equity contracts as the sale of a variable annuity fails for several reasons. First, Plaintiff's two contracts with American Equity guaranteed her a minimum 3 percent return, irrespective of the performance of the S&P 500 Index. As the Benefit Summary and Disclosure form states, the annuity contracts were "designed to accumulate value based on the average change in the S&P 500 Equity Index during each contract year, without risking loss of premium due to the S&P volatility. " In other words, in the event the S&P 500 performed poorly, Plaintiff still received a 3 percent interest payment on top of her principal annually. Consequently, American Equity assumed the investment risk and not Plaintiff who received payment regardless of how poorly the market performed.

Second, Plaintiff's benefit payments from American Equity were not directly dependant on the performance of investments made with her money. That is to say, as a structural matter, Plaintiff's contract did not operate like a variable annuity: her payments were not a function of a personalized portfolio and her principal was not held in an independent account. Had Plaintiff participated in a variable annuity, she would have retained control over the investment of her account. In this case, Plaintiff paid American Equity lump sum premiums in the amount of $ 216,289.53 and $ 64,214.32 and signed a contract that guaranteed her a 3 percent return or more if the S&P 500 Index faired well. Moreover, at no point does Plaintiff's complaint allege that her premiums were maintained in separate accounts or that, for some reason, they should have been -- the keystone characteristic of all variable annuity contracts. See Investment Company Act of 1940, 15 U.S.C. § 80a-1 (requiring that all variable annuity policies must be registered with the SEC as investment companies).

Finally, Plaintiff focuses on the fact that her return over and above the guarantee depended on the performance of the S&P 500 Index. In that way, her annuity contract did involve an element of risk and uncertainty. However, this argument is not conclusive for Plaintiff in these circumstances. Defendants actually bore as much or more of the risk than Plaintiff. American Equity guaranteed Plaintiff at least three percent of the return or the S&P 500 Index based on whichever was greater. If American Equity was unable to surpass this indexed rate in its own investment of the Plaintiff's premium, then it was the loser. More importantly, Plaintiff's risk was not that she would lose the value of her initial investment, but rather the risk that had she chosen a different contract her money might have been worth more than 134 percent at the end of the ten-year contract period. That type of risk -- that she could have gotten a better deal but for the pressure she encountered to enter into this particular contract -- is not the type of risk central to determining whether a security exists. See VALIC, 359 U.S. at 71 (noting that "it is no answer to say that the risk of declining returns in times of depression is the reciprocal of the fixed-dollar annuitant's risk of loss of purchasing power when prices are high and gain of purchasing power when they are low"). Because the Defendants assumed a much greater risk, Plaintiff's investment seems a lot more like insurance and less like an investment for the Plaintiff. Id.

For all these reasons, the Court finds Plaintiff's American Equity contracts are more like "fixed annuities" and therefore are excluded from the definition of "security" under the Supreme Court's opinions in VALIC and United Benefit.

B.

The Court could end its inquiry here. However, the Security and Exchange Commission Rule 151 Safe Harbor, 17 C.F.R. § 230.151, also merits discussion because it guarantees certain types of annuities an exemption from federal securities law. See Securities Act Release 33-6658 (Sept. 17, 1986) (noting that a contract which satisfies Rule 151 will be excluded from all provisions of the Securities Act). Subsection (a) of Rule 151 provides:

Any annuity contract or optional annuity contract (a contract) shall be deemed to be within the provisions of section 3(a)(8) of the Securities Act of 1933 (15 U.S.C. 77c(a)(8)), Provided,

(1) The annuity or optional annuity contract is issued by a corporation (the insurer) subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia;

(2) The insurer assumes the investment risk under the contract as prescribed in paragraph (b) of this section; and

(3) The Contract is not marketed primarily as an investment

17 C.F.R. § 230.151(a). [Footnote 8]

The Court concludes that the three-prong test provided by the Rule 151 Safe Harbor further shows that the American Equity contract is a non-security. Because all parties appear to concede the existence of the first prong, [Footnote 9] the Court will focus its discussion on the remaining parts of the test in dispute.

 [Footnote 8] On August 20, 1997, the SEC requested comments on the status of equity index annuities such as the one at issue in this case. Equity Index Insurance Products, SEC Release No. 33-7438, 1997 SEC LEXIS 1691, at *5 (Aug. 20, 1997). The SEC explained:

[Footnote 8 continued] Equity index insurance products combine features of traditional insurance products (guaranteed minimum return and traditional securities (return linked to equity markets). Depending on the mix of features in any insurance product, including an equity index insurance product, the product may or may not be entitled to exemption under the Securities Act as an "insurance policy" or "annuity contract." To date, most equity index annuities have not been registered under the Securities Act, although commentators have acknowledged that substantial uncertainty exists whether all of these products are entitled to exemption from registration.

[Footnote 8 continued] The SEC has made no further comment on the status of this request. The Court merely notes this request for comment as evidence that, though the issue remains unsolved, the presumption remains that Rule 151 applies to annuities such as the one in this case. In any event, Plaintiff does not contest the applicability of the Rule 151 test in this case, but rather focuses on refuting the application of the test put forth by the Defendants.

[Foonote 9] The first prong of the Rule 151 test requires that:

[Footnote 9 continued] The annuity or optional annuity contract is issued by a corporation (the insurer) subject to the supervision of the insurance commissioner, bank commission, or any agency or officer performing like functions, of any State or Territory of the United States or District of Columbia

[Footnote 9 continued] Plaintiff implicitly acknowledged the existence of this oversight when her son filed a compliant with Kentucky Department of Insurance and an investigation was opened.

The second prong of the Safe Harbor test requires that the "insurer assumes the investment risk under the contract" and then sets out three criteria, all of which the American Equity annuities meet in this case. 17 C.F.R. § 230.151(b). [Footnote 10] Under the first criteria, American Equity assumes the investment risk if "the value of the contract does not vary according to the investment experience of a separate account." Id. Nothing in Plaintiff's complaint suggests that the value of her annuity varies with the result of a separate account maintained by American Equity. To the contrary, as noted in the American Equity brochure attached to the Complaint, American Equity did not invest Plaintiff's money, but rather attempted to ensure the safety of it by maintaining a portfolio comprised of investment grade bonds, cash and cash equivalents. [See Plaintiff's Complaint Exh. H.] In other words, the value of Plaintiff's contract was not dependant on a separate account maintained by American Equity. Her funds were instead commingled with other American Equity Funds and any return over the three percent guarantee fluctuated based on the S&P 500 Index. Plaintiff thus did not pay American Equity to invest her premium, but rather purchased an insurance plan. Because it is clear Plaintiff's money was not maintained under a separate account and Plaintiff provides no argument to the contrary, subsection(b)(1) is satisfied. Berent v. Kemper Corp., 780 F. Supp. 431, 442 (E.D. Mich. 1991), aff'd 973 F.2d 1291 (6th Cir. 1992).

 [Footnote 10] An insurer is deemed to assume the investment risk under the contract pursuant to Rule 151(a)(2) if:

[Footnote 10 continued] (1) The value of the contract does not vary according to the investment experience of a separate account;

[Footnote 10 continued] (2) The insurer for the life of the contract

[Footnote 10 continued] (i) Guarantees the principal amount of the purchase payments and interest credited thereto, less any deduction (without regard to its timing) for sales administrative or other expenses or charges; and

[Footnote 10 continued] (ii) Credits a specified rate of interest (as defined in paragraph (c) of this section) to net purchase payments and interest credited thereto; and

[Footnote 10 continued] (3) The insurer guarantees that the rate of any interest to be credited in excess of that described in paragraph (b)(2)(ii) of this section will not be modified more frequently than once per year.

[Footnote 10 continued] 17 C.F.R. § 230.151(b).

Subsection (b)(2) of the investment risk prong is also satisfied. American Equity guaranteed the Plaintiff the principal amount of the purchase payments and interests, less deductions for sales, administrative, and other expenses. The contracts provided a minimum guaranteed contract value of 100 percent of the single premium plus 3 percent interest. [See p.1 of both Exhs. A and B of Defendant American Equity's Appendix.] That one of Plaintiff's contracts, generated only 1 percent income because of a poor performance by the S&P 500 Index does not change the analysis. Plaintiff's account was nevertheless credited 3 percent for that year. [See Plaintiff's Complaint Exh. O.] Plaintiff argues that the 134 percent guarantee only applies if the annuitant holds the policy for a minimum of ten years. This is evidence, she argues, of a guarantee under only certain conditions. But Plaintiff misses the point. This feature of her contract is not connected with the extent to which she shouldered the risk of investment, but rather is related to the deferral aspect which is entirely independent of the fixed/ variable analysis. Additionally, the fact that Plaintiff was entitled to retain her premium at any point during the life of the contract further disproves her claim that she assumed a significant investment risk.

The last Rule 151 investment risk criterion is that any interest credited in excess of the guaranteed minimum must not be modified more frequently than once per year. The contracts provide that the initial "Participation Rate" (the rate of excess interest credited) is guaranteed for the first year, and then may change only annually. [See Defendant American Equity's Exhs. A and B] , thus satisfying this criterion.

Finally, the third prong of Rule 151 requirement requires that the policies not be marketed primarily as investments. Plaintiff is correct in noting that the American Equity brochure and contract made reference to the success of the American Equity portfolio and that it advertised the S&P 500 indexing feature. However, making reference to investments in the context of assuring the security of an annuitant's premium, and an aggressive marketing strategy related to the potential for growing that premium have distinct legal significance. For instance, in United Benefit, the Supreme Court cited United Benefit's reliance on the possibility of investment return as evidence of an "appeal to the purchaser not on the usual basis of stability and security but on the prospect of 'growth' through sound investment management." 387 U.S. at 211 (emphasis added). In contrast, in Otto, the Seventh Circuit concluded, "Although the award of discretionary excess interest and VALIC's investment experience were given some emphasis, the fixed annuity ... was marketed primarily on the basis of its stability and security." 814 F.2d at 1134. Thus this Court must determine, based on Plaintiff's Complaint, if it appears the marketing emphasis was clearly more correlated to the prospect growth in lieu of stability.

American Equity's brochure, though it mentions the company's "sound financial management," does so in the context of explaining that the company promises "stability and flexibility." [See Plaintiff's Complaint, Exh. H] . In addition, the contract itself states plainly just before Plaintiff's signature, "[I] understand that past S&P 500 Index activity is not intended to predict future activity and that the S&P 500 Index does not include dividends." [See Defendant American Equity's Exhs. A and B] . Moreover, the one-page summary Plaintiff signed, which focused on how her Contract Value was calculated at any one point to assure her the initial principal plus interest, did not emphasize the potential increase in her assets, but focused on explaining to her that she was guaranteed her principal plus three percent interest. In totality, the Court finds Plaintiff's allegation that "Defendant caused Plaintiff" to purchase the two annuities coupled with the terms provided in the contracts for those annuities does not demonstrate that the policy was "marketed" as an investment. Thus, the Court must conclude that the American Equity annuities are protected by the Rule 151 Safe Harbor.

III.

In sum, because the American Equity annuities at issue are exempt from federal securities laws both under Section 3(a)(8) and Rule 151, there is no legal basis for Plaintiff's complaints under the Securities and Exchange Act of 1934. Counts I and II of Plaintiff's complaint are dismissed.

Because the Court finds there is no viable federal claim in this action on which to predicate supplemental jurisdiction, the Court will exercise its discretion to dismiss supplemental state law claims pursuant to pursuant to 28 U.S.C. § 1367(c)(3). See United Mine Workers of America v. Gibbs, 383 U.S. 715, 726, 16 L. Ed. 2d 218, 86 S. Ct. 1130 (1966); see also Musson Theatrical, Inc. v. Federal Express Corp., 89 F.3d 1244, 1255 (6th Cir. 1996). Counts III-X are therefore dismissed without prejudice.

The Court will enter an order consistent with this Memorandum Opinion.

JOHN G. HEYBURN II

CHIEF JUDGE, U.S. DISTRICT COURT

9/27/02

ORDER

The Court has considered Defendants' motion to dismiss. Being otherwise sufficiently advised,

IT IS HEREBY ORDERED that Defendants' motions to dismiss are SUSTAINED and the Court DISMISSES WITH PREJUDICE Counts I and II.

IT IS FURTHER ORDERED that the Court DISMISSES WITHOUT PREJUDICE Counts III, IV, V, VI, VII, VIII, IX, and X.

This is a final and appealable order.

This 27Th day of September, 2002.

JOHN G. HEYBURN II

CHIEF JUDGE, U.S. DISTRICT COURT

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National Association of Securities Dealers (NASD)

Notice 05-50, August 2005

SUGGESTED ROUTING

Legal & Compliance – Operations – Registered Representatives – Senior Management – Executive Representatives – Insurance Variable Contracts

KEY TOPICS

Equity-Indexed Annuities Rule 3030 (Outside Business Activities of an Associated Person) – Rule 3040 (Private Securities Transactions of an Associated Person) – Supervision

GUIDANCE

Equity-Indexed Annuities: Member Responsibilities for Supervising Sales of Unregistered Equity-Indexed Annuities

Executive Summary

This Notice to Members addresses the responsibility of firms to supervise the sale by their associated persons of equity-indexed annuities (EIAs) that are not registered under the federal securities laws.1

Questions/Further Information

Questions concerning this Notice may be directed to Thomas M. Selman, Senior Vice President, Investment Companies/Corporate Financing, (240) 386-4500.

Background and Discussion

Equity-indexed annuities are financial instruments in which the issuer, usually an insurance company, guarantees a stated interest rate and some protection from loss of principal, and provides an opportunity to earn additional interest based on the performance of a securities market index. Some EIAs are not registered under the Securities Act of 1933 (the Securities Act) based on a determination that they are insurance products that fall within that statute’s Section 3(a)(8) exemption and therefore are not considered to be securities.2

According to one recently published estimate, in 2004 sales of equity-indexed annuities increased over 50 percent, from $14 billion in 2003 to an estimated $22 billion.3

1. Investor Protection Issues Presented by Equity-Indexed Annuities

EIAs are complex investments. Many EIAs permit investors to participate in only a stated percentage of an increase in an index. Many of these investments also impose a “cap rate” that represents the maximum annual account value percentage increase allowed to investors. Unregistered EIAs typically do not provide for investor participation in the dividends accumulated on the securities represented by the index.4 EIAs have other features that contribute to their complexity such as minimum guarantees and fees and expenses, including surrender charges, premium bonuses, and multiple premium payment arrangements. In addition, investors may assume mistakenly that EIAs provide the same returns as an index mutual fund.

NASD is concerned about the manner in which associated persons are marketing and selling unregistered EIAs, and the absence of adequate supervision of these sales practices. We have seen sales material for unregistered EIAs that do not fully describe the features and risks of the product. For example, we have seen the following claims:

·          “What if the market goes down and you would lose nothing? The market goes up-you gain!”

·          “A Win/Win Investment Vehicle!”

·          “How Your Retirement Funds Can Have: Security of Principal, Higher Than CD Rates of Interest, Opportunity for Growth (No Losses)”

·          “Pick up where Social Security leaves off with NEW tax-deferred annuities…featuring… 2 indexed accounts linked to a popular stock market index.”

·          If you’re looking for upside potential and no market downside look no further than [name of EIA]. This fixed annuity… enables you to make the most of S&P 500 Index gains…”

·          “Growth Potential without Market Risk.”

We understand that some associated persons who also act as insurance agents might be using this type of sales material in their insurance sales capacity. NASD is concerned that the unsupervised use of such sales material could confuse or mislead investors. If sales pieces containing these statements were deemed to be broker-dealer communications with the public, then they would be subject to the NASD advertising rules, and would have to provide a balanced description of the features and risks of the product.

Moreover, because of the product’s complexity, some associated persons might have difficulty understanding all of the features of the product and determining the extent to which those features meet the needs of the customer. While unregistered EIAs may be appropriate for some retail investors, they are not suitable for all investors. For example, possible surrender charges and the combination of caps and participation rates associated with a particular product are factors that must be considered in any suitability determination.

2. The Uncertain Status of Unregistered Equity-Indexed Annuities

The question of whether a particular EIA is an insurance product or a security is complicated and depends upon the particular facts and circumstances concerning the instrument offered or sold. NASD does not seek to resolve that issue in this Notice; nor is this Notice intended to describe those circumstances in which an EIA might be deemed to be a security. However, a brief summary of the applicable provisions of the federal securities laws may be useful.

Section 2(a)(1) of the Securities Act broadly defines “security” to include such financial instruments as evidence of indebtedness, participation in profit-sharing agreements, and investment contracts. Section 3(a)(8) generally exempts from the Securities Act any security that is an “insurance or endowment policy or annuity contract or optional annuity contract, issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner, or any agency or officer performing like functions, of any State or Territory of the United States or the District of Columbia.”

In 1986, the Commission adopted Rule 151, a “safe harbor” under the Securities Act, which clarifies when certain annuity contracts are exempted securities under Section 3(a)(8). The fundamental construct of Rule 151 is derived from prior judicial interpretations of Section 3(a)(8). Consequently, the Commission has stated that the rationale underlying the conditions set forth in the rule are, along with applicable judicial interpretations, relevant to any Section 3(a)(8) analysis.5

In order for the Rule 151 safe harbor to apply:

·          the product must be issued by an insurer that is subject to state insurance regulation;

·          the insurer must assume investment risk, as provided in paragraph (b) of the rule; and

·          the product may not be marketed primarily as an investment.

As noted above, the status of any particular EIA under the safe harbor (or under Section 3(a)(8)) will depend on the facts and circumstances. In 1997 the Commission issued a concept release requesting comment regarding EIAs.6

3. Supervision under Rule 3030 and Rule 3040

Many firms assume that EIAs that are not registered under the Securities Act are insurance products and not securities. These firms treat the sale of unregistered EIAs by associated persons in their capacity as insurance agents as an outside business activity under Rule 3030, beyond the mandated purview of the firm’s supervision. Rule 3030 does not require that the firm supervise or even approve an outside business activity, although a firm may choose to deny or limit the ability of associated persons to engage in the activity. Rule 3030 simply requires that an associated person promptly notify the firm in writing that he is engaging in a business activity outside the scope of his relationship with the firm.

However, if a particular EIA were a security, and an associated person sold the EIA outside the regular scope of his employment with the firm, Rule 3040 requires that the firm treat the sale as a private securities transaction and supervise the sale in accordance with the provisions of that rule. The associated person must notify the firm in writing before participating in a private securities transaction. If the associated person will receive compensation for the transaction, the firm must provide written approval of his participation in the transaction. If the firm does approve the participation, it must record the transaction on its books and records and supervise the associated person’s participation in the transaction as if the transaction were executed on behalf of the firm.

A broker-dealer runs certain risks in applying Rule 3030 to the sale of an unregistered EIA on the assumption that the product is not a security. It is often unclear whether a particular EIA qualifies for the exemption under Section 3(a)(8), since the analysis is made on a case-by-case basis and may turn on the particular features and marketing materials associated with the product. As a result, if a particular EIA did not qualify for the exemption, a firm might incorrectly treat the EIA transaction as an outside business activity under Rule 3030 rather than a private securities transaction under Rule 3040 and thereby fail to supervise sales of the product as required by NASD rules.

Perhaps for these reasons, some firms require that associated persons obtain firm approval to sell exempt insurance products. Other firms require that their associated persons obtain more specific approval to sell unregistered EIAs. Still other firms maintain a list of approved EIAs and prohibit the sale of all others.

4. Supervisory Measures Due to the uncertainty as to whether a particular unregistered EIA may be a security, as well as the potential regulatory violations and investor protection issues that would arise by the marketing and sale of unregistered EIAs that are deemed to be securities, firms must adopt special procedures under Rule 3030 with respect to these products. In particular, firms must require that their associated persons promptly notify the firm in writing when they intend to sell unregistered EIAs. Moreover, all recommendations to liquidate or surrender a registered security such as a mutual fund, variable annuity, or variable life contract must be suitable, including where such liquidations or surrender are for the purpose of funding the purchase of an unregistered EIA.

As discussed above, NASD is not taking a position on whether a particular EIA is a security, nor are we attempting to describe the circumstances in which an EIA would be deemed a security. However, the uncertainty of this matter has led some firms to treat an associated person’s sale of an unregistered EIA outside the regular course or scope of his employment with the firm, as a private securities transaction. These firms supervise the sale according to Rule 3040 procedures. Firms are well advised to consider whether they should take a similar approach. Firms should consider maintaining a list of acceptable unregistered EIAs and prohibiting their associated persons from selling any other unregistered EIA, unless the associated person notifies the firm in writing that he intends to recommend an unregistered EIA that is not on the firm’s list, and receives the firm’s written confirmation that the sale of the unregistered EIA is acceptable.

Firms are encouraged to consider whether other supervisory procedures also might help protect the firm’s customers. For example, a firm could require that all sales of unregistered EIAs occur through the firm. If an associated person is selling the unregistered EIA through the firm, the firm must supervise the marketing material, suitability analysis, and other sales practices associated with the recommendation of unregistered EIAs in the same manner that it supervises the sale of securities.

Firms also must provide any associated person selling any unregistered EIA through the firm with the proper training to understand the EIA’s features and the extent to which the EIA meets the needs of a particular customer. The fact that an associated person holds a license as an insurance agent may not adequately qualify him to understand the features of an EIA or the extent to which an EIA meets the needs of a particular customer.

Of course, in this as in all other areas, NASD expects every associated person to comply with the procedures adopted by his firm.

Endnotes

1 The sale of an EIA registered under the federal 4 securities laws is subject to the full panoply of regulation applicable to the sale of any security.

The principles articulated in this Notice apply to EIAs that are sold by associated persons of a broker-dealer, whether the EIA has been manufactured by an insurance company that is affiliated with the broker-dealer or by an unaffiliated insurance company.

2 The Securities and Exchange Commission (the Commission) has previously stated that Congress intended any insurance contract falling within Section 3(a)(8) to be excluded from all provisions of the Securities Act notwithstanding the language of the Act indicating that Section 3(a)(8) is an exemption from registration but 6 not the antifraud provisions. See Definition of “Annuity Contract or Optional Annuity Contract,” Securities Act Release No. 6558 (Nov. 21, 1984), 49 Fed. Reg. 46750, 46753 (Nov. 28, 1984).

3 “A Do-It-Yourself Kit for Investors: Build Your Own Equity-Indexed Annuity,” The Wall Street Journal (January 26, 2005).

4. The index return may be calculated in a variety of ways, such as the “annual reset” method, under which the index starting point is reset each contract year; the “point-to-point” method, under which the change in the index from the start of a term is compared to the index at the end of the term; and the “annual high-water mark with look-back” method, which is a variation on the point-to-point method except that it compares the index starting point to the highest anniversary value during the term.

5. Securities Act Release No. 6645, 35 SEC Docket 952 (May 29, 1986) (adopting Rule 151) (“Adopting Release”).

6. Request for Comment on Equity-Indexed Products, Securities Act Release No. 7438; File No. S7-22-97 (August 20, 1997). At least one court has ruled on the question of whether an EIA is a security. The court granted a motion to dismiss based upon the finding that the EIA, which was the subject of litigation, in that case was exempt from the federal securities laws. See Malone v. Addision Insurance Marketing, 225 F. Supp. 2d 743 (W.D. Ky. 2002).

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