Federal Appeals Court Vacates SEC Rule on Fixed Index Annuities

A federal appeals court has ruled that an SEC regulation on fixed index annuities, while reasonably adopted, did not take into account its effect on efficiency, competition and capital formation. In Rule 151A, the SEC removed fixed indexed annuities from the exemption for annuity contracts bestowed by Securities Act Section 3(a)(8) and placed them under Commission regulation. In vacating Rule 151A, a panel of the D.C. Circuit Court of Appeals held that the SEC’s consideration of the effect of the rule on efficiency, competition and capital formation, as required by the Securities Act, was arbitrary and capricious. However, the SEC’s decision to regulate fixed indexed annuities and not allow them to rely on the Section 3(a)(8) exemption was a reasonable interpretation of an ambiguous statute.

A fixed index annuity is a hybrid financial product. Unlike traditional fixed annuities, the purchaser’s rate of return is not based upon a guaranteed interest rate. In fixed index annuities, the insurance company credits the purchaser with a return that is based on the performance of a securities index, such as the Dow Jones Industrial Average. Depending on the performance of the securities index to which a particular annuity is tied, the return on a fixed index annuity might be much higher or lower than the guaranteed rate of return offered by a traditional fixed annuity. Section 929J of the Dodd-Frank Wall Street Reform Act would essentially preempt federal securities regulation of equity indexed annuities.

The SEC adopted Rule 151A in order to clarify the status under the federal securities laws of indexed annuities, under which payments to the purchaser are dependent on the performance of a securities index. The rule defines indexed annuities as not being annuity contracts under the 3(a)(8) exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.

Finding the rulemaking process defective, the appeals panel rejected as flawed the SEC’s reasoning that adopting Rule 151A would enhance competition by resolving the current uncertainty over the legal status of fixed index annuities. The panel said that the lack of clarity resulting from the uncertain legal status of a financial product is only another way of saying that there was not a regulation in place before the adoption of Rule 151A.

In the court’s view, the SEC cannot justify the adoption of a particular rule based solely on the assertion that the existence of a rule provides greater clarity to an area that remained unclear in the absence of any rule. Whatever rule the SEC chose to adopt could equally be said to make the previously unregulated market clearer than it would be without that adoption. The fact that federal regulation of fixed index annuities would bring clarity to this area of the law is not helpful in assessing the effect that Rule 151A has on competition.

While creating a rule that resolves the uncertain legal status of fixed index annuities might be said to improve competition, the court said that conclusion could be asserted regardless of whether the rule deems such instruments to fall within the SEC’s regulatory reach or outside of it. The court said the SEC would achieve a similar clarity if it declined to regulate fixed index annuities. The Securities Act test does not ask for an analysis of whether any rule would have an effect on competition. Rather, it asks for an analysis of whether the specific rule the SEC adopted will promote efficiency, competition, and capital formation. The SEC’s reasoning with respect to competition supports at most the conclusion that any SEC action in this area could promote competition, the court noted, but does not establish Rule 151A’s effect on competition.

The SEC’s competition analysis also failed because the SEC did not make any finding about the existing level of competition in the marketplace under the state law regime. The SEC asserted that competition would increase based upon its expectation that Rule 151A would require fuller public disclosure of the terms of fixed index annuities and thereby increase price transparency. The SEC could not accurately assess any potential increase or decrease in competition, however, because it did not assess the baseline level of price transparency and information disclosure under state law.

The court said the SEC’s analysis of the efficiency of Rule 151A was similarly arbitrary and capricious. The SEC concluded that Rule 151A would promote efficiency because the required disclosures under the rule would enable investors to make more informed investment decisions about purchasing indexed annuities. The panel found that the SEC’s analysis was incomplete because it failed to determine whether, under the existing regime, sufficient protections existed to enable investors to make informed investment decisions and sellers to make suitable recommendations to investors.

The court said the SEC’s failure to analyze the efficiency of the existing state law regime rendered arbitrary and capricious the SEC’s judgment that applying federal securities law would increase efficiency. This flawed efficiency analysis also rendered the capital formation analysis arbitrary and capricious. The SEC’s conclusion that Rule 151A would promote capital formation was significantly based on the flawed presumption that the enhanced investor protections under Rule 151A would increase market efficiency, but the court said this analysis fell with the failure of its underlying premise.

The court also held that the SEC’s interpretation of an ambiguous statute was based in reason. By their nature, fixed index annuities appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of growth through sound investment management. While a fixed index annuity is akin to an annuity contract with respect to its pay-in and guaranteed minimum value of purchase payment features, it is more like a security in that the index-based return of a fixed index annuity is not known until the end of a crediting cycle, as the rate is based on the actual performance of a specified securities index during that period. Fixed index annuities, like securities, have variability in the potential return that results in a risk to the purchaser. By contrast, an exempt annuity contract avoids this variability by guaranteeing the interest rate ahead of time.

In the court’s view, Rule 151A is the SEC’s means of ensuring greater protection for consumers exposed to greater risk when insurers are exposed to less risk than normal. The rule sets forth a test to distinguish between those contracts where the insurer bears more risk by paying a fixed amount, and those in which purchasers bear more risk because they will receive a variable amount that is dependent upon fluctuating stock market prices. The panel concluded that such an approach in light of this risk assessment was reasonable.

American Equity Investment Life Insurance Co. v. SEC (DCCir) will be published in a forthcoming Report.