Financial Services: protecting investors

By James J. Eccleston
Shaheen, Novoselsky, Staat, Filipowski & Eccleston

Recently, the Securities and Exchange Commission published for public comment its proposed new rule aimed at protecting investors, especially senior investors, against the abuses associated with the marketing and sale of equity indexed annuities.

Sales of equity indexed annuities have grown dramatically in recent years, with $25 billion sold in 2007, for a total value of $123 billion of equity indexed annuities held by investors.

Let’s examine why the SEC is concerned, what it proposes to do, and how the proposed rule will protect investors.

First, the SEC is concerned because complaints associated with equity indexed annuities have risen dramatically. Commentators quip that the products are ‘’sold, not bought,” to imply that high-pressure sales tactics often are involved. State securities regulators identify the products ”as among the most pervasive products involved in senior investment fraud.”

Likewise, a 2005 notice to members issued by the National Association of Securities Dealers (now the Financial Industry Regulatory Authority) cited concerns ”about the manner in which persons associated with broker-dealers were marketing unregistered indexed annuities and the absence of adequate supervision of those sales practices.”

That notice also ”expressed NASD’s concern with indexed annuity sales materials that do not fully describe the features and risks of the products.”

A joint examination conducted in 2007 by the SEC, FINRA, and state regulators ”identified potentially misleading sales materials and potential suitability issues” related to investment products, commonly including indexed annuities, at so-called ”free lunch” seminars. Accordingly, working with state regulators, the SEC has made ”cracking down on fraud in this area a top priority,” and the ”proposed rulemaking is a big part of that effort.”

Second, let’s examine what the SEC is proposing.

As background, the challenge for the SEC has been to make a convincing argument that this kind of annuity is less of an insurance product and more of a securities product that should be regulated as a security.

Why the challenge? Sec. 3(a)(8) of the Securities Act provides an exemption for certain insurance contracts. Additionally, the U.S. Supreme Court has weighed in on what constitutes insurance, to be regulated by state insurance commissioners, and what constitutes securities, to be regulated by the SEC.

According to the Court, Congress intended to include in the insurance exemption only those policies and contracts that include a ”true underwriting of risks” and ”investment risk-taking” by the insurer. The assumption of a risk does not ”by itself create an insurance provision under the federal definition.”

With that Supreme Court guidance in mind, the SEC proposes: ”Individuals who purchased indexed annuities are exposed to a significant investment risk i.e., the volatility of the underlying securities index Indexed annuities are attractive to purchasers because they promise to offer market-related gains. Thus, these purchasers obtain indexed annuity contracts for many of the same reasons that individuals purchase mutual funds and variable annuities [both of which are securities], and open brokerage accounts.”

The SEC also addresses a feature of the equity indexed annuity that removes some risk from the product; a guaranteed certain minimum value to the purchaser. The SEC states that, although the insurance company guarantees this certain minimum value, that value typically is less than 90 percent of the money contributed.

As a result, the SEC concludes: ”Such indexed annuity contracts provide some protection against the risk of loss, but these provisions do not, ‘by [themselves,] create an insurance provision under the federal definition.’ Rather, these provisions reduce but do not eliminate a purchaser’s exposure to investment risk under the contract. These contracts may to some degree be insured, but that degree may be too small to make the indexed annuity a contract of insurance.”

Accordingly, the SEC proposes a new definition of ”annuity contract” that would define a class of indexed annuities that are outside the scope of Sec. 3(a)(8) of the Securities Act.

Third, how will this proposal protect investors? If adopted, investors no longer will suffer from the shortcomings of a patchwork of state insurance commissioners. Instead, equity indexed annuities purchasers will receive the full protection of the securities laws. Investors will receive ”the benefits of federally mandated disclosure and sales practice protections.”

More specifically, the SEC states: ”These investor protections include registration under the Securities Act, and our requirements related to truthful and complete disclosure of the investment to potential purchasers. In addition, investors would enjoy the benefits of protections against fraud and misrepresentation, and would benefit from additional safeguards against abusive sales practices by unscrupulous marketers. In the future, these protections may significantly reduce the problem of investors being harmed by inappropriate sales of equity indexed investments.”

Let’s hope so!

jeccleston@snsfe-law.com