What effect does this rule have on efficiency, competition, and capital formation?
We finally have the long-awaited decision (American Equity Investment Life Insurance Company, et al. v. Securities and Exchange Commission No. 09-1021, July 21, 2009) by the Circuit Court of Appeals for the District of Columbia Circuit. This decision relates to Rule 151A (the "Rule") that was adopted by the SEC that determined that index annuities are "securities" within the meaning of the Securities Act of 1933 (the "Act"). This decision determined that the SEC did not abuse its authority in determining that index annuities were "securities," but that the SEC had not fulfilled its statutory duty in its consideration of the effect that the Rule would have on "efficiency, competition and capital formation" as is required under the Administrative Procedures Act (the "APA"). The court remanded the case back to the SEC for reconsideration. We do not yet know whether the SEC will reconsider the Rule and re-adopt it, or if it will decide to let the matter drop.
The court's analysis is interesting. The Rule determined that index annuities, when pegged to a securities index, are subject to the full scope of the provisions of the Act. This would require registration of the index annuities with the SEC, the use of a prospectus in the sales process, and licensing of sales personnel under a broker-dealer that is a member of FINRA. The implementation of the Rule would markedly change the way index annuities are designed and sold.
The court first analyzed whether the SEC had standing to determine whether index annuities are "securities" within the meaning of the Act or were exempt under Section 3(a)(8) of the Act. This section basically defines "annuities" as being exempt from the registration provisions of the Act to the extent that such products are regulated by state insurance regulators. It also results in an exemption from the licensing requirements imposed by FINRA on the sale of registered securities. Fifty years ago the U.S. Supreme Court determined that variable annuities, even though they were regulated by state insurance regulators and were treated as annuities for purposes of state insurance law, were not the type of annuities that Congress intended to exempt when the Act was first adopted and were therefore "investment company securities" that were subject to the same SEC regulation as mutual funds.
In its consideration of the Rule, the Circuit Court stated that if a statute that is administered by a regulatory body is ambiguous by its terms, then deference will be given to the regulatory body's determinations regarding such a statute. Therefore, although the court seemed to have reservations regarding the accuracy of the legal characterization of index annuities as "securities," it ruled that the SEC had not abused its discretion in the adoption of the Rule. Nevertheless, the court remanded the case back to the SEC for reconsideration, ruling that the APA requires that a regulatory body such as the SEC is obligated to consider the impact of a rule on efficiency, competition, and capital formation and that the SEC had not done an adequate job of such consideration before the Rule was adopted.
This ruling leaves us a curious anomaly. The court says that index annuities are "securities" within the meaning of the Act, but that the SEC cannot adopt a rule to require them to be registered unless such a requirement is not harmful to efficiency, competition, and capital formation. Presumably, this concept could apply to any "security" proposed to be regulated by the SEC. This is indeed curious because we have always presumed that any financial instrument that meets the definition of a "security" is subject to SEC requirements unless specifically exempted. A large part of the anomaly is due to the fact that the requirements under the APA are of relatively recent vintage and the large bulk of SEC oversight of "securities" has been in place for decades. It is interesting to speculate what the result might have been if the original attempts to regulate variable annuities were to take place today, instead of 50 years ago. It is difficult to find that the labyrinth of regulatory requirements applied to variable annuities is not harmful to "efficiency, competition and capital formation." Indeed, we are sure that the primary motivation for the attack by the issuers and sellers of index annuities on the Rule was an attempt to avoid the expensive and often inconsistent regulatory process already applied to variable annuities. We are sure there is no other financial product that is the subject of so much regulatory oversight by so many regulators as is the case with variable annuities.
Of course, the original proceeding that resulted in SEC regulation of variable annuities was not a rule-making process, but an enforcement action to obtain an order to require insurers to "cease and desist" from issuing unregistered variable annuities. Perhaps the results might have been different with respect to index annuities if the same course of action had been pursued by the SEC.
This leaves us with the question, where do we go from here? The SEC should have little difficulty shoring up its findings relative to "efficiency, competition and capital formation," unless it decides to take a pass on the entire subject. Some commentators have speculated that the court's decision merely gives the index annuity industry time to seek a legislative solution to the problem by getting a specific exemption for index annuities from the Act. These commentators seem to recognize that the APA requirements are more likely to represent "motion rather than progress" in that the necessary determinations are more mechanical than substantive. This is clearly not a good time to seek legislation to avoid regulation. The environment at the present time is directed to much more regulation, not less. Moreover, the current chair of the SEC, Mary Shapiro, is the one who fired the first shot in the direction of requiring more regulation for index annuities when she headed FINRA (then the NASD). It is unlikely that she is any more favorably disposed to index annuities in her new position than she was in her old one.
We can speculate that, regardless of what happens over the next few months, it is likely that we have not seen the last of this issue. It is probably inevitable that the question of whether index annuities are or are not "securities" will end up at the U.S. Supreme Court and that it will take years before we see final resolution.