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Duplicative, confusing, and legally inaccurate: the SEC's attempt to regulate fixed indexed annuities.

I. Introduction
II. Background
   A. Introduction to Fixed Indexed Annuities
      1. Minimum Guaranteed Interest Rates and Index Crediting
      2. Limitation on FIA Yields
      3. Distributions and Withdrawals
      4. Insurance Companies' Use of Consumer Premiums
   B. The Law and Its Effect on Fixed Indexed Annuities Prior to
       the SEC's Rule
      1. The McCarran-Ferguson Act of 1945 and Insurance Regulation
      2. The Statutory Definition of a Security
      3. The Judicial System's Analysis of What Constitutes a Security
        a. Cases Construing the '33 Act
        b. Construing the Rule 151 Safe Harbor
   C. The SEC's Rule 151A
      1. Legal Justification
      2. Practical Justification
III. Analysis
   A. Is the SEC's Definition of Investment Risk Correct?
   B. Does the Difference Between Investment Risk and Insurance Risk
       Matter?
   C. Does the SEC's Rule 151A Comport with Established Law?
      1. The '33 Act's Section 3(a)(8)
      2. Supreme Court Precedent
   D. What Will Federal Regulation Do that State Regulation Cannot Do?
   E. What Costs Will the Rule Create if Enacted?
IV. Recommendation
V. Conclusion


I. INTRODUCTION

Across the United States many investors have seen their portfolios' value fall significantly during the recent credit crisis. Because of this, investors are reminded of the risk associated with equity investments. This is the risk equity investors take in exchange for the chance to participate in theoretically limitless profits. One financial product--a Fixed Indexed Annuity (FIA)--offers its owners the opportunity to participate in the gains of the stock market (albeit, not limitless gains), with zero downside risk. However, the cost of an FIA may soon increase, thanks to a new rule that the Securities and Exchange Commission (SEC) recently finalized, Rule 151A (the Rule), which is now tied up in litigation. (1) The D.C. Court of Appeals remanded the rule to the SEC to address problems with the SEC's analysis of "efficiency, competition and capital formation" as required under section 2(b) of the Securities Act of 1933 ('33 Act). (2) Should the Rule withstand the aforementioned challenges, it would reclassify all FIAs as securities products rather than insurance products (3) as soon as mid-2012. (4)

Since the creation of FIAs in the mid 1990s, the SEC has not classified FIAs as subject to federal securities law. (5) The SEC now argues that the rule is necessary to thwart the use of predatory sales tactics in the marketing of FIAs. (6) However, others argue that the Rule could have devastating effects on the indexed annuity industry. (7) Even the SEC projects that the Rule will cost the industry at least $100 million in the first year. (8) This Note argues that the SEC's Rule is based on an incorrect theory of investment risk, overemphasizes the difference between investment risk and insurance risk, is unsupported by judicial precedent, and imposes substantial costs in exchange for limited benefits. Consequently, this Note argues that on remand the SEC should withdraw the rule or, alternatively, the D.C. Circuit should vacate the Rule.

Part II this Note explains the current situation, including a discussion of the mechanics of an FIA, the relevant law as it applies to FIAs, and the SEC's Rule 151A. Part III of this Note offers a critique of the SEC's Rule 151A, including an examination of the Rule's definition of investment risk, a consideration of the difference between investment risk and insurance risk, the application of relevant law to the SEC's Rule, a comparison of state regulation to the potential of federal regulation, and a cost analysis of the Rule. Finally, in Part IV, this Note recommends that the D.C. Circuit vacate the SEC's Rule.

II. BACKGROUND

In order to understand the impracticability of the SEC's Rule, it is important to first understand how an FIA works, including the guaranteed return on an FIA, the calculation of the actual return, and the insurance companies' use of consumer premiums. Moreover, an understanding of the SEC's Rule 151A, and the ways that the rule contradicts existing law, requires knowledge of the current state of the law surrounding FIAs--including the SEC's previous FIA-related rules, statutory law, and the judicial system's interpretation of statutory and administrative regulation. Finally, the SEC's Rule is of substantial length, so a summary is necessary.

A. Introduction to Fixed Indexed Annuities

Insurance companies that sell FIAs (9) offer consumers a product that has a minimum guaranteed return as well as the potential for returns exceeding the minimum guaranteed return. (10) The return on an FIA will never be lower than the minimum guaranteed return. However, the FIA's return can exceed the minimum guaranteed return (11) since the FIA's returns are derived from an index. (12) If the index performs well, the FIA's returns can exceed the minimum amount guaranteed. (13) Conversely, if the index's performance is negative, the FIA returns will not drop below the minimum guarantee.

1. Minimum Guaranteed Interest Rates and Index Crediting

The minimum guaranteed interest rate (MGIR), compounded over the life of the FIA contract, provides the floor below which the value of the contract cannot go. (14) The index-credited value of the contract is the value derived from the relevant index; the more the index increases in value, the more the contract's index-credited value increases. (15) Each year the insurance company applies the MGIR to the contract as well as the rate derived from the index. (16) The contract essentially maintains two values over its life: (1) the MGIR value and (2) the index-credited value. (17) At any given time, the value of the contract is the higher of the MGIR or the index-credited value. The MGIR value is fixed, whereas the index-credited value is not fixed. At the end of the contract's term, (18) the value of the MGIR will be at least equal to the total premiums paid. (19) If the indexcredited value of the contract is greater than the MGIR value, then the MGIR value is irrelevant.

Often the MGIR is applied to only a portion of the premiums. For example, the company might apply the MGIR to 87.5% of premiums. Thus, if the company says its MGIR is 3%, then the effective rate is lower than 3%, provided the rate is applied to less than 100% of premiums. (20) The SEC offered an example of a policy that pays 1% MGIR on 87.5% of premiums. (21) This policy would require 13 years until the MGIR is equal to premiums paid. (22) However, most FIAs come with an MGIR of three percent, (23) not one percent as the SEC used in its example.

2. Limitation on FIA Yields

The FIA owner's premium payments are not directly linked to the index's performance. In contrast, a mutual fund's value might directly link to an underlying index--the fund's value changes in the same amount as the underlying index. (24) Several limits that insurance companies impose on the FIA returns create this difference between the index performance and the FIA return.

One such limitation on FIA returns is known as a "participation rate." A policy's participation rate is the percentage of the index's growth that is credited to the FIA's return. (25) For example, if the relevant index has a 100-point increase and the participation rate is 70%, then the FIA will "participate" in 70 out of the 100 points' worth of index value increase. (26) The remaining 30 points offset the insurance companies' costs. (27)

Another limitation is the "cap." The policy-issuing company might limit the amount of return that it will credit to a policy. (28) To illustrate, if a cap is 10%, then no matter how much the relevant index increases (e.g., 12%) the FIA will only have a return of 10%. If the index returns are lower than the cap level, then the cap is essentially meaningless for that year.

3. Distributions and Withdrawals

The FIA policy holder can make withdrawals before or after the term expires. (29) Surrender charges might apply to some withdrawals that the policyholder makes prior to the term expiration. (30) Surrender charges are a percentage deduction on the withdrawal. (31) The company does not subject withdrawals made after the term expires to surrender charges. (32) Normally, the amount of the surrender charge decreases over the life of the policy. (33)

Not all withdrawals are subject to surrender charges, however. Most policies offer withdrawals of up to 10% of the contract's value before surrender charges are applied. (34) Furthermore, once the term of the contract expires, the policyholder can withdraw all the money free of surrender charges. (35) In the alternative, the policyholder can elect to annuitize (36) the value of the policy. (37) Although only a minority of policy owners elect to annuitize the policy, this option provides a benefit that the policyholder cannot outlive. (38) Because of this option, FIAs can be classified as "deferred annuities." Annuity payments under a deferred annuity occur after the lapse of a period of time between the initial payment of the premium(s) and the commencement of the annuity payments. (39) During the deferral period the value of the premium grows; in the case of the FIA the premium grows via either the indexing component or the MGIR. (40)

Finally, the typical FIA includes a "death benefit." (41) This means that if the annuity owner or annuitant (42) dies, then the issuing company pays out the entire value of the contract to the beneficiary. (43) The death benefit is available to the beneficiaries even when the surrender period has not expired; in fact, this is the real value of the death benefit. (44)

4. Insurance Companies' Use of Consumer Premiums

The consumer's premiums are not invested in the index to which the contract is linked. (45) Instead, the company combines all premiums to create a general fund. (46) The company uses that general fund to invest in a combination of fixed investment products and derivatives. (47) The insurance company uses the majority of the fund for investing in fixed products such as government bonds or other bonds rated high enough to comport with state insurance law requirements. (48) The fixed portion of the company's investments is calculated to provide a return which equals the MGIR yield on all the policies. (49) The other portion of the fund, the non-fixed portion, is then invested in call options (50) on the linked index. (51) The return on the options provides for the contract's yield above the MGIR. (52)

Ultimately, an FIA policy's value is subject to the writing company's solvency. (53) The insurance company is not free to allocate consumer premiums at the whim of its discretion. (54) Each state, as well as the District of Columbia, has in place a set of solvency rules. (55) These rules require insurance companies to maintain a minimum amount of capital and compel the companies to limit the amount of risk they accept. (56)

To further ensure that companies will remain solvent, state insurance laws require that the companies participate in an insurance "guaranty fund." (57) These funds operate much like the Federal Deposit Insurance Corporation, which insures banking deposits. Typically, a guaranty fund will insure a life insurance contract up to $100,000. (58)

B. The Law and Its Effect on Fixed Indexed Annuities Prior to the SEC's Rule

1. The McCarran-Ferguson Act of 1945 and Insurance Regulation

Broadly speaking, states regulate insurance companies because the federal government has expressly made it the states' responsibility to regulate the industry under the McCarran-Ferguson Act of 1945 (McCarran Act). (59) The McCarran Act is clear in its intention to leave insurance regulation to the states as well as to eliminate any federal role in such regulation. (60) Accordingly, the legislation reads: "no Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, or which imposes a fee or tax upon such business, unless such Act specifically relates to the business of insurance." (61)

The SEC's Rule would not directly change the McCarran Act, but would change its ultimate effect because FIAs would no longer be subject to the McCarran Act if declared securities. This is because, under existing law, FIAs are considered insurance products and not securities. (62) The same state-centered regulation scheme does not apply to securities. The federal government regulates securities under the '33 Act and other federal securities laws. This legislation grants regulatory authority to the SEC. (63)

2. The Statutory Definition of a Security

The '33 Act provides a definition of "securities" as well as certain explicit exemptions from the definition. Under the '33 Act a security is
   any note, stock, treasury stock, security future, bond, debenture,
   evidence of indebtedness, certificate of interest or participation
   in any profit-sharing agreement, collateral-trust certificate,
   preorganization certificate or subscription, transferable share,
   investment contract, voting-trust certificate, certificate of
   deposit for a security ..., [or] any interest or instrument
   commonly known as a "security".... (64)


For the purposes of FIAs the most controversial term in the preceding definition is "investment contract." Also controversial is the '33 Act's exception for "[a]ny 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." (65) The Supreme Court, on two occasions, has ruled on the scope of this provision. (66) The Court, however, has never specifically ruled on the application of this section to the FIA industry. (67) Instead, it is the SEC's rule that seeks to make that ruling. (68)

The SEC clarified the '33 Act's exemption for insurance (section 3(a)(8)) with Rule 151 (to be distinguished from Rule 151A). (69) This rule, known as the Rule 151 Safe Harbor, provides that all products that satisfy three requirements are covered within the section 3(a)(8) exception for insurance. (70) The first requirement is that the product must be an annuity if the insurer offering the contract is subject to the supervision of some governmental regulatory agency, including state insurance commissioners. (71) The second requirement under the Safe Harbor is that the "insurer assumes the investment risk under the contract." (72) According to the SEC, the insurer assumes the investment risk providing three criteria are satisfied. (73) First, the value of the contract cannot "vary according to the investment experience of a separate account." (74) Second, for the duration of the contract, the insurer must guarantee the principal save for any amounts that are deducted for expenses--and guarantee a rate of interest on the principal that is not lower than required by state law. (75) Finally, the third element of the SEC's Safe Harbor test requires that insurers do not market their contracts as investments. (76) It is important to remember that the Safe Harbor is merely one way for insurers to guarantee that their product is within the realm of the section 3(a)(8) exemption to the '33 Act. Alternatively, the issuer of a contract could simply prove that the contract does not fall within the '33 Act's definition of security. (77)

3. The Judicial System's Analysis of What Constitutes a Security

a. Cases Construing the '33 Act

The Supreme Court's decision in SEC v. Howey is the seminal case on the definition of a "security" under the '33 Act. (78) In Howey, the plaintiffs were two corporations that owned a substantial tract of land where they operated a citrus acreage. (79) To raise capital, the corporations sold some of that land. (80) As part of the sale of land, the purchaser was also offered a "service contract," in which the corporations agreed to operate the citrus farm on the land. (81) In exchange for purchasing the land, the investor received a return that varied according to the quality of the crops. (82) In the year prior to the lawsuit, the return was around 20%. (83)

The issue for the Court was whether such an arrangement was indeed an investment contract under the '33 Act. (84) Under the '33 Act's language, the Court determined the citrus farm situation could only qualify as an "investment contract." (85) That term did not have an explicit definition, so the Court created and implemented the following definition of investment contract: "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party." (86) The Court found this contract was an investment contract and, therefore, was a security. (87)

In the years since Howey, courts have developed a four-pronged test for purposes of applying the Howey test. An investment contract exists, for purposes of the '33 Act, if the following four elements are satisfied: (1) money is invested; (2) investment is "undertaken with the expectation of profit;" (3) profits are "derived solely from the efforts of others;" and (4) a common enterprise exists. (88) While Howey remains important in considering whether any product is a security, the business venture in Howey was not an annuity and thus not directly applicable to FIAs. However, the Court has had other opportunities to apply the '33 Act to products more similar to FIAs.

The Supreme Court ruled in SEC v. Variable Annuity Life Insurance Co. (VALIC) that variable annuities were not insurance products, but instead were securities subject to federal regulation. (89) The products at issue in VALIC offered consumers something similar to a mutual fund--the consumer paid a "premium" that the insuring company invested in common stocks and other equities. (90) The owner of one of these products essentially had an interest in the companies' investment performance, but the consumer received no guarantee of any return. (91) The Court concluded that the products were securities because the products did not satisfy what the Court identified as two essential elements of insurance: (1) the presence of an "insurance or mortality" risk; and (2) a guaranteed return. (92)

In SEC v. United Benefit Life Insurance Co. (United Benefit) the Court again considered whether a product that the company referred to as an annuity was actually a security under the '33 Act. (93) The insurer in United Benefit offered a ten-year deferred annuity that guaranteed the purchaser's premium at the end of the ten-year term. (94) Once the contract matured, the consumer had two decisions. (95) First, the consumer could decide to receive a payout or to annuitize the contract's value. (96) The second decision involved the calculation of the contract's value. (97) The consumer could choose the guarantee at the end of the ten-year term. (98) Or, in the alternative, the consumer could elect to "share in [the company's] investment experience" and take a return greater than the premium if the company's "professional investment program" successfully achieved positive returns. (99)

The Court offered two holdings. First, the Court stated that the initial ten-year portion of the contract (the deferred portion) could be considered separate from the possible annuitization that followed the ten-year term for purposes of determining whether the contract was a security. (100) Second, the Court held that to qualify as insurance and not a security, the insurance company must shoulder at least some investment risk. (101) To that end, products that offer only minimal guarantees of value--in this case 100% at the end of the term--do not create sufficient investment risk for the company in order to qualify as insurance. (102)

A federal district court ruled specifically on the application of section 3(a)(8) to FIAs in Malone v. Addison. (103) In that case, American Equity Investment Life Insurance Company (AEL) (104) issued the policy in question. (105) That contract offered the consumer a guarantee of 100% of the premium plus at least 3% interest per year. (106) Any yield greater than three percent per year was based on the performance of the S&P 500 Index. (107)

The Malone v. Addison court found that the product in dispute was not a security under the '33 Act. (108) The court gave three reasons for this determination. First, the contract required AEL to pay a guaranteed interest rate, "irrespective of the performance of the S&P 500." (109) Second, the court emphasized that the contract's yield was "not directly dependent on the performance of investments made with [the plaintiff's] money." (110) Last, the court determined that AEL shouldered the majority of the investment risk due to its guarantee that the plaintiff would not lose any premium. (111)

b. Construing the Rule 151 Safe Harbor

The United States Supreme Court has not ruled on the Rule 151 Safe Harbor; in fact, litigation involving the Safe Harbor is limited. Nevertheless, the same federal district court in Malone v. Addison considered the Safe Harbor's application to FIAs. (112) Even though the court determined that the product was not subject to the '33 Act, for clarity purposes it still considered the applicability of the Safe Harbor. (113) In making this consideration, the court found that the AEL product satisfied all three prongs of the Safe Harbor test. (114) First, the court found that AEL was subject to state insurance regulation. (115) Second, the court found that AEL assumed the investment risk because "the value of the contract [did] not vary according to the investment experience of a separate account" and because of the guaranteed return of three percent interest annually. (116) Finally, the court found that the product was not marketed as an investment because the promotional material emphasized the premium's security as opposed to its potential for growth. (117)

Another federal district court determined that a contract did not satisfy the three elements of the SEC's Rule 151 Safe Harbor in Holding v. CooA:. (118) The contract at issue in that case failed the Safe Harbor test despite the product's name including "annuity." (119) The court found that this particular product was not an annuity under the Safe Harbor because it did not guarantee a specified rate of return to the contract owner. (120)

The two previously mentioned federal district courts have had their say on the Safe Harbor and its relation to the FIA. Other courts have touched on it as well. (121) However, the SEC has never ruled on whether an FIA fits within its own Safe Harbor. (122) The SEC's Rule, which is the focus of this Note, is the SEC's first comment on the subject.

C. The SEC's Rule 151A

If enacted, the SEC's Rule would reduce the scope of the Rule 151 Safe Harbor, arguably eliminating all FIAs from the Safe Harbor. (123) Under the new Rule, all products that meet the following two criteria would not be exempted from the '33 Act:

1. Products with a yield that is calculated based "in whole or in part" on the "performance during the crediting period or periods of a security, including a group or index of securities,"

2. Products where the amounts payable under the product are "more likely than not to exceed the amounts guaranteed under the contract." (124)

To justify regulating FIAs as securities, the SEC emphasizes that FIAs do not shift the investment risk from the FIA purchaser to the insurer. (125) Instead, the SEC says, individuals who purchase "indexed annuities are exposed to a significant investment risk--i.e., the volatility of the underlying securities index." (126) This is, according to the SEC, because the investor primarily assumes the risk for the "unknown, unspecified, and fluctuating securities-linked portion of the return." (127) In other words, the SEC believes the consumer is subject to investment risk if a product has undetermined upside.

1. Legal Justification

The SEC argued that its definition of investment risk is accurate according to the Supreme Court's opinion in United Benefit. (128) In that case, the Court ruled that the elimination of downside (129) was not enough, on its own, to create an insurance contract. (130) The opinion said that "the assumption of investment risk cannot by itself create an insurance provision under the federal definition." (131) Thus, according to this argument, an FIA is not an insurance contract even though it guarantees premium.

2. Practical Justification

The Commission identified four ways in which its Rule would improve the market for FIAs: (1) better disclosure; (2) more sales practice protections; (3) increased regulatory certainty; and (4) enhanced competition. (132) The SEC believes that federal regulation would ensure better disclosure because sales of federally regulated annuities would be difficult without certain disclosures explaining the details of an FIA. (133) Such disclosures, in the view of the SEC, would make comparisons of FIAs with other securities more expeditious for consumers. (134) Moreover, the threat of a federal securities violation as opposed to a state insurance violation would induce greater compliance. (135)

Requiring companies to register their FIA products would also increase sales practice protections, according to the SEC. (136) By subjecting FIAs to federal regulation, all individual dealers would have to register with a licensed broker-dealer. (137) The SEC says this process would compel agents (138) "to make only recommendations that are suitable" for the consumer because the broker-dealers would oversee the agents. (139)

The Commission also believes the Rule will provide the impetus for necessary regulatory certainty. (140) The SEC suggests that current regulation, including the Rule 151 Safe Harbor, does not provide sufficient certainty as to whether an FIA is an insurance product or a security. (141) However, the Rule will change that uncertainty and make clear that FIAs are not insurance products.

Finally, the SEC believes the Rule will increase competition in the FIA market. (142)

The SEC explains that some companies may have chosen not to enter the FIA market because of the uncertainty regarding FIA regulation. (143) Furthermore, the SEC advises, the increased disclosure requirements will create competition between FIAs and other products like mutual funds. (144) Additionally, the SEC argues that some registered broker-dealers that have not sold FIAs in the past because of regulatory uncertainty may be willing to sell FIAs once regulatory uncertainty is eliminated. (145)

The SEC recognizes that the Rule could adversely affect the profitability of companies that are heavily invested in the FIA market. (146) The Commission suggests a number of costs its Rule could impose on companies. For example, the Rule will create SEC filing fees and compliance costs associated with filing. (147) The SEC also acknowledges that the Rule will generate costs related to producing the SEC-required investor prospectus. (148) Companies that sell FIAs will also experience increased costs because of the business relationships they will need to establish with broker-dealers. (149)

Perhaps most importantly, however, the SEC concedes that the rule change could result in a loss of business. (150) In fact, it envisions that some companies that currently sell FIAs may opt to terminate their FIA business due to the new regulations. (151) This suggestion does not seem to create much concern at the SEC, however. Rather, the SEC envisions that any loss of revenue "may be offset ... by gains in revenue from the sale of other financial products, as purchasers' need for financial products will not diminish." (152) Nonetheless, despite the aforementioned costs, the SEC believes the Rule is necessary and will

bring about a net benefit to the financial industry.

III. ANALYSIS

There are four primary reasons that the SEC should rescind its Rule or that the courts should overturn the SEC's Rule. First, the SEC takes an overly broad view of investment risk. Second, the SEC incorrectly insists that there is a legally significant difference between investment risk and insurance risk. Third, the SEC's Rule is inconsistent with both statutory law and existing case law. Finally, the Rule will create costs that the Rule's benefits do not offset. This Part will explain each of these four shortcomings.

A. Is the SEC's Definition of Investment Risk Correct?

The SEC states that the FIA consumer "assumes the risk of an uncertain and fluctuating financial instrument ... [and] obtains an instrument that, by its very terms, depends on market volatility and risk." (153) According to this statement, it appears the SEC believes that undetermined upside is the same type of risk as undetermined downside. After all, the owner of an FIA assumes no more risk than the "risk" of higher returns. (154)

Historically speaking, the SEC's definition of risk is, at the very least, unique. Quite possibly, the SEC's definition of risk is historically inaccurate. In 1952 Harry Markowitz developed Modern Portfolio Theory, a method for reducing risk. (155) This theory led to the quantifying of risk. (156) To quantify risk, Markowitz's protege, William Sharpe, "calculated how much the return of stock ... varied from its mean over time." (157) While this was a significant breakthrough, this quantification of risk has proved insufficient over time. (158) In fact, Markowitz himself acknowledged in 1959 that risk analysis should not rely so heavily on standard deviation because it did not properly weigh downside. (159)

The problem is that Sharpe's formula puts too much emphasis on variance. For example, a product that produces a consistent 5% loss each year will have a lower standard deviation than a product that yields a positive return each year, albeit returns that vary from year to year. The formula would rank the least risky product (the product yielding positive returns) as the higher risk product.

To solve this problem, economists have developed new ways to quantify risk. One of the leading metrics for evaluating risk is the Sortino Ratio, named after Frank Sortino. (160) Sortino's formula measures downside risk in comparison to upside potential. (161) He says that downside risk is the only form of risk: "Risk is associated only with the bad outcomes." (162) And Sortino is not the only financial economist that now emphasizes downside rather than upside as the primary indicator of risk. Christian Pedersen and Stephen Satchell also argue that standard deviation is a flawed method for calculating risk. (163) They offer a plethora of other financial economists who have chosen to emphasize downside risk over "upside risk." (164)

In sum, the financial economics industry has chosen to move away from early theories that equated risk with both downside and upside potential. After the industry analyzed such theories, it discovered that upside was at most a minor part of the risk equation and possibly not even part of risk. Consequently, the industry has moved towards a definition of risk that emphasizes downside and not upside. Nevertheless, the SEC chose not to follow suit when crafting its Rule.

B. Does the Difference Between Investment Risk and Insurance Risk Matter?

Traditionally, legal scholars have thought that insurers could only insure pure risk-- such as the risk that a house burns down. (165) Investment risk, on the contrary, is risk that entails the possibility of upside and downside. (166) The risk behind an equity stock is considered investment risk because the value might increase or it might decrease. (167)

The SEC's Rule 151 Safe Harbor seems to indicate that an indexed annuity involves investment risk--risk that is allocated to the insurance company. (168) This allocation of risk, however, operates in a similar manner to pure insurance risk. When an individual purchases fire insurance, he is reducing the downside risk associated with owning a house, while retaining all the upside (home equity increases) associated with owning a house. When an individual purchases an FIA he is purchasing insurance against market downside while retaining all the upside. Buying an FIA is the equivalent of selling a market index short or buying a put option. Selling short and put options are often used for insurance purposes. (169) However, since neither of those vehicles retain the upside they are not actually insurance products. (170) An FIA does retain the upside, it just eliminates the downside--much like fire insurance. So the Rule 151 Safe Harbor might actually incorrectly label risk assumed by an FIA issuer as investment risk, when it is actually insurance risk.

However, even if the risk associated with an FIA is investment risk and not insurance risk, the law has not historically made that distinction dispositive for purposes of the distinction between securities and insurance. Consider the fact that the Rule 151 Safe Harbor specifically indicated that an insurance product could involve investment risk. Section (a)(2) of the rule says that "[t]he insurer assumes the investment risk under the contract." (171) However, products that meet the requirements of the Safe Harbor are not considered securities, but are instead insurance products. So, even products dealing in investment risk are insurance products provided the insurance company assumes the investment risk (and satisfies the other criteria as well).

The Supreme Court's decision in VALIC made clear that variable annuities were not insurance products because the products did not require the issuing company to take on sufficient investment risk. (172) The Supreme Court recognized that a "variable annuity places all the investment risks on the annuitant, none on the company." (173) Moreover, the Court concluded "that the concept of 'insurance' involves some investment risk-taking on the part of the company." (174) Consequently, it is not legally correct to say that only products insuring pure risk are insurance products.

In summary, it is possible, if not likely, that FIAs do in fact insure a pure risk. If that is true, then FIAs are insurance in the same way that fire insurance is classified as insurance. However, in determining whether a product is a security or an insurance product, the judicial system and the SEC have not historically considered whether a product insures investment risk or pure risk dispositive. Consequently, even if an FIA insures investment risk, the SEC should not let that determine the insurance/security classification of FIAs.

C. Does the SEC's Rule 151A Comport with Established Law?

1. The '33 Act's Section 3(a)(8)

Although the SEC says its Rule 151A is "consistent with Congressional intent," (175) the Rule actually conflicts with section 3(a)(8) in at least one of two ways. First, section 3(a)(8) of the '33 Act grants an exclusion from regulation under the '33 Act to "any insurance or endowment policy or annuity contract or optional annuity contract." (176) The judicial system has instructed that interpretation of this section should begin with the section's "plain meaning." (177) Yet, the SEC has attempted to declare which types of annuities fit within the term "annuity contract," thereby straining the plain meaning. (178)

To bump FIAs out of the '33 Act's "annuity contract" exemption, both the Rule Proposal and Final Rule argue that FIAs are not annuities because they are effectively securities. (179) The Rule Proposal suggests that naming a product an annuity does not necessarily make it an annuity. (180) To support this, the SEC used the example of variable annuities, which are considered securities. (181) However, it was the judicial system that determined that variable annuities are not substantively annuities, and thus should be regulated as securities. (182) When given the opportunity to rule on FIAs, the judicial system conversely determined that the FIAs are indeed annuities in both form and substance. (183)

The second conflict between Rule 151A and section 3(a)(8) of the '33 Act is the fact that the Rule does not recognize the legal distinction between an annuity and insurance. (184) Section 3(a)(8) does not necessarily mandate that an FIA meet the definition of insurance because the language distinguishes between insurance products and annuity products. The '33 Act refers separately to the terms "annuity" and "insurance." (185) The separate reference indicates the legislature's intent to recognize a distinction between annuities and insurance. Consequently, under the '33 Act a determination that an annuity product is not insurance is really immaterial.

To summarize, the rule is legally unsatisfactory for two reasons. First, the SEC is overruling judicial precedent. Second, the SEC's analysis fails to appreciate the statutorily prescribed distinction between annuities and insurance.

2. Supreme Court Precedent

The Supreme Court has not determined whether an FIA qualifies for the securities law exemption under section 3(a)(8) of the '33 Act. (186) In considering the VALIC and United Benefit cases, the distinction between an annuity and insurance is crucial. Both of these cases determined not what qualified as insurance, but rather what did not constitute an annuity. (187) The financial products in those cases, which the Court determined were not annuities, were subject to federal securities regulations. (188) An FIA is very different from either of the products in VALIC and United Benefit. (189) Consequently, Supreme Court precedent does not suggest FIAs should lose their annuity characterization.

In VALIC the Court ultimately determined that a product which was similar to a mutual fund was in form not an annuity and therefore was subject to federal securities regulation. (190) However, VALIC does not support the SEC's Rule because the product in VALIC is different from an FIA in three ways. First, a company that issues FIAs does not invest the consumer's premiums in the stock market; such was not the case in VALIC. (191) Second, the consumer's principal in an FIA is guaranteed, unlike the principal in VALIC. (192) In other words, an investor in a product like that in VALIC incurs downside risk, whereas the investor in an FIA incurs no downside risk. Third, the company offering an FIA incurs risk, whereas the product-issuing company in VALIC did not incur risk. (193)

The VALIC court determined that the product in question was not an insurance product because there was not a guaranteed return and there was no element of insurance or mortality risk. (194) However, an FIA does include each of those two elements. (195) In sum, VALIC says that certain products are not annuities and consequently they are not entitled to state insurance regulation. However, the products addressed in VALIC are different from an FIA. (196)

The import of United Benefit is similar to that in VALIC. The Court took issue with the relatively low principal guarantee that the United Benefit product offered. (197) Conversely, the guarantee is much more substantial for FIAs. (198) Furthermore, the Court noted significantly that the guarantee in that case was based on stock performance. (199) However, an FIA's guarantee is set independent of stock performance. (200) In sum, VALIC and United Benefit do not necessarily grant an exemption from securities law to FIAs, but their holdings certainly do not indicate that securities law applies to FIAs.

Another Supreme Court case, Howey, (201) is also relevant for purposes of FIA regulation. The SEC could make a strong argument that an FIA qualifies as an investment contract (and thus a security) under the standard put forth in Howey. (202) First, an FIA entails an investment of money. Second, an FIA consumer likely buys the product with the "expectation of a profit." Third, the FIA consumer makes no effort to produce the aforementioned profits, meaning the efforts must be attributable to the FIA company. An FIA does not fit the fourth prong of the Howey test as clearly. However, even if it is assumed that an FIA is a "common enterprise," Howey does not require that federal securities law govern FIAs. This is because Howey does not address the exemption from securities laws under section 3(a)(8) of the '33 Act. Thus, even if an FIA qualifies as an investment contract under Howey, it is exempted as an annuity or insurance product if it satisfies the exemption.

In sum, the SEC claims to use Supreme Court precedent as authority even though no direct support exists. The Court has not offered any indication that FIAs do not fall under the '33 Act's section 3(a)(8) exemption. (203) However, in Addison v. Malone a federal court did conclude that section 3(a)(8) includes FIAs. (204) Furthermore, the plain language of section 3(a)(8) appears to include FIAs. Nonetheless, despite the clarity of the statute's language and the precedent under Addison, the SEC suggests that FIAs are securities under current law.

D. What Will Federal Regulation Do that State Regulation Cannot Do?

The SEC advocates federal regulation of FIAs in part because the SEC believes that the federal regulation will help curb abuses within the industry. (205) In making its case, the SEC depends on the validity of two propositions. First, the SEC argues that the FIA industry is insufficiently regulated. (206) Second, the SEC assumes that federal regulation is superior to the current FIA regulation scheme. (207) Each of these two propositions is false.

Other than some limited anecdotal evidence, the Rule Proposal summarily concludes that state regulation is insufficient for FIAs. In support of the SEC's concerns the proposal references a publication from the National Association of Securities Dealers that warned its members of marketing abuses in the FIA industry as well as two similar notices from the Financial Industry Regulatory Authority (FINRA). (208) The SEC points to comments from Patria Struck, a former President of the North American Securities Administrators Association (NASAA), as further evidence that regulation improvements are needed in the FIA industry. (209) Ms. Struck's group has determined that FIAs are "among the most pervasive products involved in senior investment fraud." (210) The SEC also cites a study that the SEC conducted along with NASAA and FINRA that concluded some marketing techniques used in the FIA industry could "potentially" mislead consumers. (211)

Noticeably absent from the SEC's analysis is a comprehensive study of abuse in the FIA market. (212) The Rule Proposal relies heavily upon Ms. Struck and NASAA's "research." (213) The SEC's strongest empirical evidence that suggests fraud in the FIA industry is that "cases involving variable [annuities] or [FIAs] represented an estimated 65% of the caseload in Massachusetts and 60% of the caseloads in Hawaii and Mississippi." (214) However, NASAA's evidence analyzes variable annuities and FIAs collectively. (215) Variable annuities are not subject to state regulation because they are securities. (216) This statement could just as easily support the proposition that it is actually the variable annuity market that is inundated with abuse. (217) Taken one step further, the NASAA data could imply that federal regulation is inadequate.

The notices from FINRA and NASAA do not contain any specific documentation of FIA industry abuses. (218) In essence, the SEC is basing its warning on another warning, but with nothing to lend credibility to either of the warnings. Furthermore, NASAA is a professional association for securities dealers. (219) Some of the dealers may perceive that they are in competition with FIA dealers. (220) Promoting a new set of regulations for their competitors would increase compliance expenses for their competitors. (221)

Finally, while both the Rule Proposal and Final Rule did not reference it, the SEC commenced its "open meeting" (222) with a segment from a Dateline NBC television program. (223) In support of the segment's proposition that the FIA market was corrupt, NBC found only one individual victim of fraud. (224) As with the other evidence presented, this is hardly an indication that the market is replete with abuse.

In fact, more comprehensive data suggests that complaints within the FIA industry are minimal. The National Association of Insurance Commissioners (NAIC) has issued an empirical examination of the FIA industry that showed through the first quarter of 2008 state insurance commissioners only received 38 meritorious complaints. (225) In 2005 (for the entire year) this number was 105; in 2006 the number was 231; and in 2007 the number was 248. (226)

Even if the FIA market is full of fraudulent profiteers (a suggestion the SEC does little to advance), the SEC's proposed changes in regulation will not substantially improve the regulatory scheme. This is because the "proposed changes" are hardly changes, since the various state insurance commissioners (227) already provide similar regulations. (228) In fact, all insurance companies must register themselves and their individual products with each individual state insurance commissioner's office. (229) Yet, the SEC argues that federal regulation will improve both disclosure and suitability.

The SEC says that Rule 151A "extends the benefits of full and fair disclosure ... to investors in [FIAs]." (230) Specifically, according to the SEC, under federal law, proper disclosure would require information about costs, the method of computing indexed return, minimum guarantees, and benefits. (231) Furthermore, the information would be available to all potential investors on the SEC's online database. (232) The SEC addresses, at length, the benefits of the online database. For instance, according to the SEC, the online database would "enhance investors' ability to compare various [FIAs] with mutual funds, variable annuities and other securities and financial products." (233)

Such disclosure benefits of federal regulation would not fundamentally change regulation already in place under the state regulatory system. Each state's requirements are different. (234) As noted above, an insurance company may not sell their product in a given state without satisfying the requirements of the particular state. (235) Twenty-two of the states have adopted the National Association of Insurance Commissioners' Model Disclosure Rules (Model Rules). (236) Under the Model Rules, an insurance company must thoroughly explain all the features of an FIA, such as the calculation of the contract's value and the penalties assessed upon withdrawal. (237) Six of the other states have adopted portions of the NAIC's Model Rules. (238) States that have yet to implement the NAIC's Model Rules each have their own disclosure requirements, many of which are similar to those of the NAIC. (239) Some states have more specific requirements than the NAIC's Model Rules--for example, California has more stringent requirements for agents that visit the homes of senior citizens. (240) Maybe most significantly, every state requires insurance companies to offer a "free look" period on every FIA. (241) A free look period means that a policy holder can rescind the contract penalty-free within 10-20 days from the date of purchase. (242) Thus, under the current regime, insurance companies have a heavy incentive to make all necessary disclosure because consumers can terminate their FIA, penalty-free, if the consumer experiences buyer's remorse due to lack of disclosure (or any other reason). (243)

The SEC argues that consumers will be more likely to receive products that are suitable to their needs under the federal regulation than they would be under the current state regulatory regime. (244) The central precept of its theory is that individuals licensed to sell securities under federal regulation are subject to their federal "obligation to make only recommendations that are suitable." (245) However, the suggestion that federal regulation will increase suitability within the FIA market overlooks the similarities between federal and state suitability regulation. Without a distinct difference in regulatory strategy, federal regulation would have little impact on suitability within the FIA market.

Under federal law, a securities broker-dealer (246) is prohibited from recommending a security to a customer unless the broker-dealer has a "reasonable belief" that the security is appropriate for the investor. (247) In making this judgment, the broker-dealer is charged with a duty to consider the investor's situation, which includes the investor's risk threshold, financial situation, and investment portfolio composition. (248) The suitability requirements once were merely an ethical obligation for the broker-dealer; however, the suitability requirements are now codified, and a breach may result in litigation. (249)

State insurance regulation of securities is not substantially different from federal regulation of securities. Just as it did for disclosure requirements, the NAIC has issued a model for suitability requirements in the FIA industry. (250) Furthermore, at least 33 state legislatures have adopted NAIC's model suitability laws. (251) Under the NAIC model, the sales agent is required to "have reasonable grounds for believing that the recommendation is suitable for the consumer." (252) The difference between this requirement and the federal requirement is negligible.

However, the suitability requirements under the NAIC model do not stop there. The model requires that the sales agent make a reasonable effort to obtain information regarding the consumer's financial situation. (253) To promote enforcement, the underwriting insurer must maintain "written procedures" and "conduct periodic reviews" that are tailored to "assist in detecting and preventing violations." (254) Even FINRA, the securities self-regulatory organization, supports the NAIC Model Rules. (255)

Those states that have not adopted the NAIC's Model Rules have generally formulated their own suitability regulations. (256) As previously discussed, all 50 states offer a free-look period, which increases the consumer's opportunity to ensure the product is suitable. (257) This period allows the consumer extra time and extra information to determine if the product is worthy. Furthermore, because of the consumer's ability to apply increased scrutiny on account of the free-look period, the insurance companies have extra incentive to ensure their products' value. The SEC, which has incentive to divulge the shortcomings of this state-based system in order to support Rule 151A, is unable to thoroughly articulate any serious problems that federal regulation would solve. In short, states are concerned about their citizens' best interests and have enacted effective suitability regulations very similar to any "new" regulation that federal securities law would impose.

E. What Costs Will the Rule Create if Enacted?

Existing law requires the SEC to address potential FIA industry costs associated with its Rule. (258) The SEC estimates an increase in "paperwork burden" amounting to $82.5 million. (259) The SEC acknowledged the potential for diminished competition (260) in the FIA industry, other compliance costs, and the potential for FIA companies to lose revenue. (261) However, the Commission argues that the lost revenue "may be offset ... by gains in revenue from the sale of other financial products, as purchasers' need for financial products will not diminish." (262)

Another estimate suggests that the SEC's projections are inaccurate and/or incomplete. The Rule Proposal did not consider the additional costs that FIA sales agents will incur. The SEC regulatory costs will almost certainly eliminate individual sales agents from the market in their current form. One industry expert estimates that independent agents sell 90% of FIAs, and up to 70% of those insurance agents are not licensed to sell securities. (263) All independent agents without a securities license would have to register with a self-regulatory organization. (264) Obtaining that registration would cost at least $25,000 up front, plus annual costs of between $50,000 and $100,000. (265) To avoid these exorbitant costs the individual insurance agents might choose to split the costs with other agents through a large organization. (266) However, such an arrangement will still involve extra expenses, and will also limit agents' revenue as some of their commissions will go to the given national organization. (267)

Other estimates have attempted to quantify the impact on the entire insurance industry. Advantage Compendium, an FIA industry analyst, estimates that the rule would affect over 100,000 agents. (268) That same analysis estimates a total industry impact of $852 million. (269) Another more conservative projection estimates the economic impact of the Rule would be in excess of $700 million. (270)

These projections, made independent of the SEC, are significantly greater than the SEC's projections. That is unsurprising because the SEC projections are not as exhaustive as they should be since the SEC only considered the increased paper and labor costs. A complete estimate of the Rule's costs should also include all costs associated with agent registration. Once agent registration costs are added to the projection the inefficiency of the Rule becomes apparent.

IV. RECOMMENDATION

The D.C. Court of Appeals should vacate the SEC's Rule or, alternatively, the SEC should withdraw the Rule. (271) There are three primary reasons that one of the aforementioned actions should be taken. First, the SEC's definition of investment risk, while innovative, is inaccurate. Second, the Rule is contrary to established law and thus is unfair to those who relied on established law. Third, not only will the regulatory "benefits" be almost non-existent, as they are largely duplicative of the current regulatory scheme, but such duplicative benefits come at a high cost.

The SEC's definition of investment risk discourages insurers from providing their consumers with the potential for higher returns. Insurers are certainly in the industry of eliminating their consumers' risk. However, insurers that are able to create products that allow their consumers to enjoy increased upside should not be subject to the regulatory expenses associated with federal securities regulation. Otherwise, the consumer will ultimately suffer because the threat of expensive federal regulation will curtail innovation in the insurance industry.

The SEC's desire to classify FIAs as securities essentially overrules judicial precedent. (272) In Addison v. Malone a federal court ruled that the '33 Act provided an exemption that eliminates insurance products, including FIAs, from classification as a security. (273) An appellate court could overturn this decision; so too could a legislative amendment to the '33 Act. However, the SEC should respect the court's decision.

The SEC's Rule will unfairly burden an industry that has grown accustomed to the current state-based regulation regime. Since the creation of FIAs in the mid-1990s, (274) companies which sell the products have largely sold them under state regulation. Their business models were developed around the current regulatory scheme. A new regulatory scheme would undermine those models and greatly increase the economic burden stemming from regulation. (275) Such a regulatory shift is unfair given the industry's justifiable reliance on established law. (276)

Finally, the Rule is lousy public policy. The SEC's Rule comes with a cost. (277) If a cost does exist, then presumably there should be a benefit. However, in this case, the "new" federal regulations hardly offer a benefit since they will duplicate the current regulatory scheme. Moreover, even if the new regulations were likely to benefit consumers, the SEC is not telling the whole story. The costs could push FIA companies out of the industry. This would mean less supply and higher costs, provided the demand remains the same. Essentially, consumers would pay for the increase in regulation. Since only one complaint is registered per every $109 million in FIA premiums sold, (278) it seems unlikely that consumers are yearning for more regulation to the point that they would be willing to pay for it.

If companies elect to stay in the market once the new rule is implemented, they will likely push some of their increased costs onto the consumers. Once again, even if the new regulation was necessary or likely to have a positive impact, the SEC would effectively be "selling" increased regulation to the consumer (without giving the consumer the opportunity to reject the "offer"). The transaction would occur as follows: the consumer would pay the FIA companies more in fees or the FIA companies would pay less return on their FIA products in order to offset their rising regulatory costs. Thus, while the SEC argues that its Rule is grounded in a desire to benefit the consumer, its Rule is merely a forced transaction requiring increased consumer payments.

V. CONCLUSION

The D.C. Court of Appeals should vacate the Rule or the SEC should withdraw its Rule because (1) it is based on an incorrect theory of investment risk, (2) it seeks to overturn judicial precedent, and (3) the costs of the Rule greatly exceed any benefits. The SEC is in the business of regulating securities. The SEC is not in the business of overturning judicial precedent. The SEC is not in the business of selling regulation. The SEC is not in the business of developing innovative definitions of investment risk. To limit the SEC to its role, the court should side with the insurance companies and vacate the Rule if the SEC does not elect to withdraw the Rule on its own.

(1.) See generally Indexed Annuities and Certain Other Insurance Contracts, Final Rule, 74 Fed. Reg. 3138 (Jan. 16, 2009) (to be codified at 17 C.F.R. pts. 230 & 240) [hereinafter SEC Final Rule] (finalizing the SEC's Rule Proposal). See, e.g., Arthur D. Postal, Court May Toss 151A Order, Nat'l Underwriter, Nov. 12, 2009, http://www.lifeandhealthinsurancenews.com/News/2009/11/Pages/ Court-May-Toss-151A-Order.aspx (explaining the litigation ensuing the SEC's finalization of the Rule 151A order, including a motion before the D.C. Circuit to vacate the rule); see also Response of the Securities and Exchange Commission to Petition for Panel Rehearing, Am. Equity Inv. Life Ins. Co. v. SEC, (D.C. Cir. Sept. 28, 2009) (briefing the D.C. Circuit as to why the court should deny a motion to vacate Rule 151A).

(2.) Am. Equity Inv. Life Ins. Co. v. SEC, 572 F.3d 923, 934-36 (D.C. Cir. 2009).

(3.) See Indexed Annuities and Certain other Insurance Contracts, 73 Fed. Reg. 37,752 (proposed July 1, 2008) (to be codified at 17 C.F.R. pts. 230 & 240) [hereinafter SEC Rule Proposal] ("The proposed Rule would prospectively define certain indexed annuity contracts as not being 'annuity contracts' ... .").

(4.) Melanie Waddell, SEC Proposes Two-year Stay on Rule 151A on Regulating Annuities as Securities, Investment Advisor, Dec. 10, 2009, http://www.investmentadvisor.com/ news/2009/12/Pages/SEC-SeeksTwoYear-Stay-on-Rule- 151A-on-Regulating-Annuities-as-Securities.aspx (last visited Jan. 25, 2010).

(5.) The first FIA was sold in 1995. Jack Marrion, Index Annuities 8 (2003). Federal securities law requires that all companies wishing to issue securities (in most cases) register their products with the SEC. See Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 39 (2005). Registration requires that the company provide both a prospectus as well as other information to the SEC. 15 U.S.C. [section] 77f(a) (2006). The company must also give each private purchaser of the security a copy of the prospectus, which makes the required disclosures regarding the product and its features. [section] 77j(a)(1). The registration process entails substantial legal and advisory expenses. Furthermore, only licensed dealers may sell securities. [section] 78o(a)(1). Dealer licensing not only takes significant time but more importantly is a cumbersome process. See generally Josh Futterman, Note, Evasion and Flowback in the Regulation S Era: Strengthening U.S. Investor Protection while Promoting U.S. Corporate Offshore Offerings, 18 Fordham Int'l L.J. 806, 817-18 (1995) (describing the process of registering a particular product as a security); Therese H. Maynard, The Uniform Limited Offering Exemption: How "Uniform" is "Uniform?"--An Evaluation and Critique of the ULOE, 36 Emory L.J. 357, 361-64 (1987) (commenting on the registration process and the related expenses); Stephen Choi, Regulating Investors Not Issuers: A Market-Based Proposal, 88 Cal. L. Rev. 279, 281-84 (2000) (explaining the dealer registration process).

(6.) SEC Rule Proposal, supra note 3, at 37,752-53; SEC Final Rule, supra note 1, at 3138.

(7.) See, e.g., Jack Marrion, Comments on the SEC Proposal 4, http://www.figmarketing.com/pdf/ Jack%20Marrion.pdf (arguing in part that the rigors of the SEC regulation will be difficult for the FIA industry to sustain) (last visited Feb. 2, 2010).

(8.) SEC Rule Proposal, supra note 3, at 37,773.

(9.) Companies that sell FIAs include, but are not limited to, Allianz Life Insurance Company of North America, American Equity Investment Life Insurance Company, Aviva Life and Annuity Company, Conseco Insurance Company, EquiTrust Life Insurance Company, Life Insurance Company of the Southwest, Midland National Life Insurance Company, National Western Life Insurance Company, North American Company for Life and Health Insurance, and OM Financial Life Insurance Company. Letter from Eugene Scalia & Daniel J. Davis, Gibson, Dunn & Crutcher LLP to the SEC, Comments of the Coalition for Indexed Products Regarding Proposed Rule 151A 1 (Sept. 10, 2008), available at http://www.sec.gov/comments/s7-14-08/s71408-1840.pdf.

(10.) Gary O. Cohen, ALI-ABA Course of Study Materials, III.A.1 (Nov. 2006). For example, if the stock market goes up, the contract's value will be higher than the minimum guaranteed interest rate, rendering the minimum guaranteed interest rate moot. However, if the market does not go up, the minimum guaranteed interest rate will determine the contract's value.

(11.) Id.

(12.) Id. An index is a compilation of a given set of stocks; the index's performance is wholly linked to the performance of the stocks that comprise the specific index. Id. pt. III.B.3. An FIA is often linked to the S&P 500, a compilation of 500 of the largest stocks available. Id.

(13.) Cohen, supra note 10, pt. III.A.1.

(14.) SEC Rule Proposal, supra note 3, at 37,755.

(15.) Cohen, supra note 10, pt. III.B.1. There are several index-crediting methods; see Marrion, supra note 5, at 38-57 for several of the various options.

(16.) Cohen, supra note 10, pt. III.B.5.a.

(17.) See id. pt. III.B (explaining the relationship between the MGIR and index-credited value).

(18.) The "term" of an annuity is typically the "length of time that surrender penalties may be charged." Marrion, supra note 5, at 29. Surrender penalties are explained infra at Part II.A.3.

(19.) Marrion, supra note 5, at 19 (detailing the guaranteed return for fixed annuities).

(20.) Three percent applied to 87.5% of premiums produces an effective rate of 2.625%.

(21.) SEC Rule Proposal, supra note 3, at 37,755.

(22.) See id. (explaining that some contracts do not guarantee 100% of the premiums). In this example, it takes 13 years for the interest applied to 87.5% of the premiums to equal 100% of the premiums paid. Id.

(23.) Marrion, supra note 5, at 29.

(24.) See John C. Coffee, Jr., Liquidity Versus Control: The Institutional Investor as Corporate Monitor, 91 Colum. L. Rev. 1277, 1339 (1991) (explaining that an indexed fund seeks to "duplicate" the stock market).

(25.) Marrion, supra note 5, at 25-27. Furthermore, contracts allow for participation rate changes from year to year. Id. The insurance companies use the premiums to invest in options and fixed products. Id. When option prices fall and/or interest rates rise the insurance company will have more money and can afford to increase participation rates. Id. at 26. When a policy allows for changes in participation rates, the issuing company must commit to a minimum participation rate. Cohen, supra note 10, pt. III.B.5.b.

(26.) See Marrion, supra note 5, at 25-27 (explaining the mechanics of a participation rate).

(27.) See id. at 27 (explaining the purpose of a participation rate).

(28.) See Cohen, supra note 10, at 12 (explaining surrender charges).

(29.) See Marrion, supra note 5, at 50 (explaining the consequences of an early withdrawal).

(30.) Id.

(31.) For example, if a policyholder wishes to withdraw $1000 and the surrender penalty is 10% then the consumer will only receive $900, but $1000 will be deducted from the contract's value.

(32.) See Marrion, supra note 5, at 10 ("Almost all deferred annuities charge a surrender penalty if the policy is cashed in prior to the end of the surrender period.").

(33.) Surrender charges can be as high as 25%, and the term can last up to 18 years. Id. at 31.

(34.) SEC Rule Proposal, supra note 3, at 37,754.

(35.) Marrion, supra note 5, at 29. Technically, the term of an annuity is the length of the contract's life, including the annuitization period. Id. However, the surrender charge period is often referred to as the term, so this Note will do the same. Id.

(36.) Policyholders annuitize their policies when they elect to receive the value in structured payments. Id. at 6. For example, the policyholder could receive a set number of payments (e.g., one payment per month for 60 months) or the policy holder could receive payments for the remainder of his or her life.

(37.) See id. (discussing the likelihood of annuitization).

(38.) Marrion, supra note 5, at 6.

(39.) Cohen, supra note 10, at 8.

(40.) Id. For an explanation of the index crediting method and the MGIR, see supra Part II.A.1.

(41.) See Marrion supra note 5, at 11 (explaining that companies almost never apply surrender charges in the event of policy holder death).

(42.) The policy is taken out on the annuitant's life, but the annuitant does not necessarily pay the premiums.

(43.) Scalia & Davis, supra note 9, at 3.

(44.) Cohen, supra note 10, at 7 (explaining the features and value of death benefits).

(45.) See Scalia & Davis, supra note 9, at 4 (listing the investment vehicles that insurance companies use for the FIA premiums).

(46.) Id.

(47.) Id.

(48.) See Marrion, supra note 5, at 27 (explaining the insurance companies' use of options as an investment vehicle). For example, American Equity Investment Life Insurance Company allocates approximately 80% of its general fund to fixed bonds. Letter from Eric Gorman, Skadden, Arps, Slate, Meagher & Flom LLP to the SEC, Supplemental Comment Regarding Release Nos. 33-8,933 and 34-58,022, "Indexed Annuities and Certain other Insurance Contracts," at 10 (2008), http://www.sec.gov/comments/s7-1408/s71408-1939.pdf.

(49.) See Marrion, supra note 5, at 23 (noting that the insurance company uses the bond investments to protect the MGIR).

(50.) A call option gives the owner the right to buy a stock at a given price prior to a given time in the future. See Charles T. Terry, Option Pricing Theory and the Economic Incentive Analysis of Non-recourse Acquisition Liabilities, 12 Am. J. Tax Pol'Y 273, 327 (1995) (defining a call option).

(51.) Marrion, supra note 5, at 21.

(52.) Id.

(53.) Cf. Scalia & Davis, supra note 9, at 4 (emphasizing the security of the FIA companies' investment strategies, thereby implying the strong correlation between company solvency and policy values).

(54.) Gorman, supra note 48, at 10.

(55.) Id. at 9 n.14.

(56.) Id.

(57.) Scalia & Davis, supra note 9, at 4.

(58.) Id.

(59.) Jonathan Macey & Geoffrey Miller, The McCarran-Ferguson Act of 1945: Reconceiving the Federal Role in Insurance Regulation, 68 N.Y.U. L. Rev. 13, 14 (1993).

(60.) See McCarran-Ferguson Act of 1945, 15 U.S.C. [section] 1012(a) (2000) ("[T]he business of insurance, and every person engaged therein, shall be subject to the laws of the several States which relate to the regulation or taxation of such business.").

(61.) [section] 1012(b).

(62.) See generally Malone v. Addison, 225 F. Supp. 2d 743 (W.D. Ky. 2002) (concluding that under existing law an FIA was an insurance product and not a security).

(63.) SEC v. Howey, 328 U.S. 293, 294 (1946). See infra Part III.D for an analysis and comparison of state insurance regulations and federal securities regulations.

(64.) Securities Act of 1933, 15 U.S.C. [section] 77b(a)(1) (2006) (emphasis added).

(65.) [section] 77c(a)(8).

(66.) SEC Rule Proposal, supra note 3, at 37, 755. For more on these two cases see infra Part II.B.3.a.

(67.) SEC Rule Proposal, supra note 3, at 37,755.

(68.) Id. at 37,752-53.

(69.) See generally Rule 151 Safe Harbor, 17 C.F.R. [section] 230.151 (2008) (declaring that the SEC will leave certain FIAs to state regulation).

(70.) Id.

(71.) Id.

(72.) Id.

(73.) Id.

(74.) 17 C.F.R. [section] 230.151.

(75.) The SEC requires companies to comply with the National Association's required rate of interest in the event that the contract is issued in a state with no requirement. 17 C.F.R. [section] 230.151(c).

(76.) 17 C.F.R. [section] 230.151.

(77.) See generally Malone v. Addison, 225 F. Supp. 2d 743 (W.D. Ky. 2002) (ruling that the product in issue was legally considered an insurance product irrespective of the Rule 151 Safe Harbor).

(78.) Shanah D. Glick, Are Viatical Settlements Securities Within the Regulatory Control of the Securities Act of1933?, 60 U. Chi. L. Rev. 957, 969 (1993).

(79.) SEC v. Howey, 328 U.S. 293, 295 (1946).

(80.) Id.

(81.) Id.

(82.) See id. (addressing the firm's advertising of past performance of the crops and the corresponding yields).

(83.) Id. at 295-96.

(84.) Howey, 328 U.S. at 294.

(85.) Id. at 297-98.

(86.) Id. at 298-99.

(87.) See id. at 300.
   Thus, all the elements of a profit-seeking business venture are
   present here. The investors provide the capital and share in the
   earnings and profits; the promoters manage, control and operate the
   enterprise. It follows that the arrangements whereby the investors'
   interests are made manifest involve investment contracts,
   regardless of the legal terminology in which such contracts are
   clothed.


Id.

(88.) Glick, supra note 78, at 969.

(89.) See generally SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65 (1959) (ruling that variable annuities are not insurance products).

(90.) Id. at 69-70.

(91.) Id. at 71.

(92.) Steven Williams, Note, Distinguishing "Insurance" from Investment Products under the McCarran-Ferguson Act: Crafting a Rule of Decision, 98 Colum. L. Rev. 1996, 2004 (1998).

(93.) SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 204 (1967).

(94.) Id. at 205. The insurer only guaranteed 50% of the premium at the beginning of the term, and over the course of the ten-year term the guaranteed portion of the premium escalated. Id. No increase in premium was promised, merely a return of the premium. Id.

(95.) Id.

(96.) United Benefit, 387 U.S. at 205.

(97.) Id.

(98.) Id.

(99.) Id. at 204-05, 208.

(100.) Id. at 207.

(101.) United Benefit, 387 U.S. at 210.

(102.) Id.

(103.) See Malone v. Addison, 225 F. Supp. 2d 743, 752 (W.D. Ky. 2002) (holding that the product in issue was not a security under section 3(a)(8) of the '33 Act).

(104.) American Equity is a prominent dealer of FIAs. See Gorman, supra note 48, at 1 (arguing on behalf of American Equity against the SEC's Rule Proposal).

(105.) Malone, 225 F. Supp. 2d at 745-17.

(106.) Id. at 746.

(107.) Id.

(108.) Id. at 751.

(109.) Id. at 750.

(110.) Malone, 225 F. Supp. 2d at 750.

(111.) Id.

(112.) Id. at 748.

(113.) See id. at 751 (noting that the court's holding on section 3(a)(8) was sufficient for deciding the case).

(114.) Id.

(115.) Malone, 225 F. Supp. 2d at 751-52.

(116.) Id. at 752.

(117.) See id. at 753 (finding that "making reference to investments in the context of assuring the security of annuitant's premium, and an aggressive marketing strategy related to the potential for growing that premium have distinct legal significance").

(118.) Holding v. Cook, 521 F. Supp. 2d 832, 838 (C.D. Ill. 2007).

(119.) Id. at 836.

(120.) Id. at 837.

(121.) See, e.g., Otto v. Variable Annuity Life Ins. Co., 814 F.2d 1127, 1141 (7th Cir. 1987) (finding that the defendant's product did not fall outside of the Rule 151 Safe Harbor).

(122.) SEC Rule Proposal, supra note 3, at 37,752-53; SEC Final Rule, supra note 1, at 3138-39; see also Cohen, supra note 10, at 1 (explaining the ramifications of Rule 151A).

(123.) The SEC does not actually say this, but instead says that the intended "effect of this provision is to eliminate variable annuities from the scope of the Rule." SEC Rule Proposal, supra note 3, at 37,758; SEC Final Rule, supra note 1, at 3149. The definition the SEC proposes, however, seems to clearly include FIA products. Furthermore, the entire FIA industry has reacted to this rule as though it targets FIA products. See, e.g., Scalia & Davis, supra note 9 (arguing on behalf of several sellers of FIA products in opposition to this rule because of its potential to adversely impact the industry). Moreover, the SEC's Final Rule includes extensive discussion of the comments the SEC received in response to the Rule Proposal. This discussion reveals that the FIA industry was strongly opposed to the Rule Proposal. See SEC Final Rule, supra note 1, at 3144-47, 3147 nn.74-77 (footnoting the comment letters received from numerous companies dealing largely in the FIA industry, such as American Equity, Old Mutual, Sammons, and Second National Western).

(124.) SEC Final Rule, supra note 1, at 3149.

(125.) SEC Rule Proposal, supra note 3, at 37,757; SEC Final Rule, supra note 1, at 3144-45.

(126.) SEC Rule Proposal, supra note 3, at 37,753; SEC Final Rule, supra note 1, at 3145.

(127.) SEC Rule Proposal, supra note 3, at 37,757; see also SEC Final Rule, supra note 1, at 3145 ("The purchaser of an indexed annuity assumes investment risk because his or her return is not known in advance and therefore varies from its expected value.").

(128.) SEC Rule Proposal, supra note 3, at 37,757 n.40; SEC Final Rule, supra note 1, at 3144 ("Our investment risk analysis is an application of the Court's reasoning in ... United Benefit."); SEC v. United Benefit, 387 U.S. 202, 206 (1967).

(129.) Owners of FIAs do not risk losing their premiums since the underwriting companies guarantee them. See supra Part II. A.

(130.) United Benefit, 387 U.S. at 211.

(131.) Id. at 211 (9-0 decision) (Brennan, J., concurring).

(132.) SEC Rule Proposal, supra note 3, at 37,768-69. The SEC actually lists five "benefits" of this Rule; however, the one that is not listed does not apply to FIAs.

(133.) See id. at 37,768 (suggesting disclosures including "information about costs (such as surrender charges); the method of computing indexed return (e.g., applicable index, method for determining change in index, caps, participation rates, spreads); minimum guarantees, as well as guarantees, or lack thereof, with respect to the method for computing indexed return; and benefits (lump sum, as well as annuity and death benefits)").

(134.) Id. The SEC offers a database in which all registered products are easily searchable. See SEC EDGAR Database, http ://www.sec.gov/edgar.shtml.

(135.) SEC Rule Proposal, supra note 3, at 37,768; see also SEC Final Rule, supra note 1, at 3148-49.

(136.) SEC Rule Proposal, supra note 3, at 37,768. However, the SEC appeared to back off this argument to a certain extent in its Final Rule. That document read:
   A vital aspect of the Commission's mission is investor protection.
   As a result, reports of sales practice abuses surrounding a
   product, indexed annuities, whose status has long been unresolved
   under the federal securities laws, are a matter of grave concern to
   us. However, the presence or absence of sales practice abuses is
   irrelevant in determining whether an annuity contract is entitled
   to the exemption from federal securities laws.


SEC Final Rule, supra note 1, at 3148-49. While the SEC's final analysis expressed in the previous quote may be valid, the SEC's original argument, made in the Rule Proposal but also at the SEC meeting at which the Proposal was introduced, relied heavily on its "abusive practices" argument. Perhaps more important--and disingenuous--is the SEC's claiming "[s]ales [p]ractice [protections" as a benefit of Rule 151A in the Final Rule (after claiming it was not part of the calculation). SEC Final Rule, supra note 1, at 3162-63. Thus, the "sales practice protections" argument must be addressed when determining whether Rule 151A should be implemented.

(137.) Scalia & Davis, supra note 9, at 24. Broker-dealers are registered with a self-regulatory organization, which SEC rules require to "promote just and equitable principles of trade." Frederick Mark Gedicks, Suitability Claims and Purchases of Unrecommended Securities: An Agency Theory of Broker-Dealer Liability, 37 Ariz. St. L.J. 535, 557-58 (2005).

(138.) The term "agent" refers to the actual individual who makes the sale of an FIA. In other words, to buy an FIA, a consumer should meet with an agent.

(139.) SEC Rule Proposal, supra note 3, at 37,768.

(140.) Id. at 37,769; SEC Final Rule, supra note 1, at 3138-39.

(141.) SEC Rule Proposal, supra note 3, at 37,769; SEC Final Rule, supra note 1, at 3139.

(142.) SEC Rule Proposal, supra note 3, at 37,769; SEC Final Rule, supra note 1, at 3170-71.

(143.) SEC Rule Proposal, supra note 3, at 37,769; SEC Final Rule, supra note 1, at 3145.

(144.) SEC Rule Proposal, supra note 3, at 37,769; SEC Final Rule, supra note 1, at 3170.

(145.) SEC Rule Proposal, supra note 3, at 37,769; SEC Final Rule, supra note 1, at 3148.

(146.) See SEC Rule Proposal, supra note 3 at, 37,769-70 (listing the costs associated with the rule that the SEC has identified); SEC Final Rule, supra note 1, at 3164-69 (same).

(147.) SEC Rule Proposal, supra note 3, at 37,770.

(148.) Id. A prospectus is a document that makes disclosures about the advantages and disadvantages of an investment devise. See Gedicks, supra note 137, at 582 n.169 (explaining the requirements of a prospectus).

(149.) SEC Rule Proposal, supra note 3, at 37,770.

(150.) Id.; SEC Final Rule, supra note 1, at 3168.

(151.) SEC Final Rule, supra note 1, at 3168.

(152.) Id.

(153.) SEC Rule Proposal, supra note 3, at 37,757.

(154.) Mark F. Meyer, Statement of Mark F. Meyer, Ph.D., Regarding SEC Proposed Rule 151A, in Scalia & Davis, supra note 9, app. at 5.

(155.) Andrea Trachtenberg & Alyssa A. Lappen, Risk Reconsidered, Fin. Planning, Jan. 2001, at 75.

(156.) Id.

(157.) Id. at 75-76. Sharpe's calculation is made by taking the difference between the risk-free rate (Treasury bills) and the security or portfolio's yield and then dividing by the standard deviation of the portfolio's returns. Id. The standard deviation is the return's average margin from the average return. Id. at 76. Consequently, returns that vary a great deal will produce a higher standard deviation than returns that are constant.

(158.) See Trachtenberg & Lappen, supra note 155, at 75 (arguing that standard deviation should be relied on less in quantifying risk).

(159.) See Meyer, supra note 154, at 2 (explaining that Markowitz acknowledged emphasizing downside risk was most appropriate). Moreover, when Markowitz laid the foundation for Modern Portfolio Theory in 1952, he relied heavily on standard deviation, but knew that his metric failed to weigh downside heavily enough. Christian S. Pedersen & Stephen E. Satchell, On the Foundation of Performance Measures Under Asymmetric Returns, 2 Quantitative Fin. 217, 220 (2002). However, Markowitz could not correct this problem because of computational difficulties. Id. Consequently, he settled for the less than ideal formula. Id.

(160.) Trachtenberg & Lappen, supra note 156, at 76.

(161.) Id.

(162.) Id.

(163.) See Pedersen & Satchell, supra note 159, at 220 (explaining that semi-variance is more appropriate than standard deviation). "Semi-variance" is the metric that the Sortino Ratio uses. Id. Semi-variance measures downside. See Meyer, supra note 154, at 2 (equating semi-variance with downside risk analysis).

(164.) See Pedersen & Satchell, supra note 159, at 220 ("The use of downside risk measures has been advocated by numerous academics and practitioners in finance."). The authors named the following financial economists who have advocated measuring risk through downside risk: Markowitz (1952), Roy (1952), Bawa (1975), Bawa & Lindenberg (1977), Menezes, Geiss et al. (1980), Harlow & Rao (1989), Huang et al. (2001). Id.

(165.) Williams, supra note 92, at 2017-18.

(166.) Id.

(167.) See Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure, 71 S. Cal. L. Rev. 303, 389 (1998) (explaining that the unpredictability of returns creates investment risk).

(168.) See Rule 151 Safe Harbor, 17 C.F.R. [section] 230.151(a)(2) (2008) ("The insurer assumes the investment risk under the contract.").

(169.) See, e.g., Thomas A. Smith, Institutions and Entrepreneurs in American Corporate Finance, 85 Cal. L. Rev. 1, 45 (1997) (explaining the concept of portfolio insurance).

(170.) Short selling and put options essentially turn downside into upside and upside into downside (i.e., when the value of an index goes up, those who short it or buy a put on it lose value).

(171.) 17 C.F.R. [section] 230.151(a)(2).

(172.) See SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65, 71 (1959) ("[W]e conclude that the concept of 'insurance' involves some investment risk-taking on the part of the company.").

(173.) Id. at 71.

(174.) Id.

(175.) SEC Rule Proposal, supra note 3, at 37,753.

(176.) Securities Act of 1933 [section] 3(a)(8), 15 U.S.C. [section] 77c (2006).

(177.) Scalia & Davis, supra note 9, at 6 (citing BedRoc Ltd. v. United States, 541 U.S. 176, 183 (2004)).

(178.) See SEC Rule Proposal, supra note 3, at 37,756-57 (providing the proposed new criteria for determining which annuities are securities and which are not securities); SEC Final Rule, supra note 1, at 3149.

(179.) SEC Rule Proposal, supra note 3, at 37,756.

(180.) Id. at 37,756-57.

(181.) Id. at 37,757.

(182.) See generally SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967) (explaining that a product-- such as a "variable annuity"--is not an annuity even though it calls itself an annuity, if the issuing company does not shoulder at least some investment risk); SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65 (1959) (ruling that a product called an annuity is not an annuity if the issuing company does not guarantee the principal and assume some risk).

(183.) Malone v. Addison, 225 F. Supp. 2d 743, 751 (W.D. Ky. 2002).

(184.) See John Alan Appleman & Jean Appleman, Insurance Law and Practice [section] 84, at 295 ("[C]ontracts of life insurance and of annuity are distinctly different.").

(185.) See Securities Act of 1933 [section] 3(a)(8), 15 U.S.C. [section] 77c (2006) (defining one exception as "any insurance or endowment policy or annuity contract or optional annuity contract").

(186.) Cohen, supra note 10, at 3.

(187.) See supra notes 89-99 and accompanying text (explaining the holdings in VALIC and United Benefit).

(188.) See id.

(189.) See infra notes 190-200 and accompanying text (comparing the products in VALIC and United Benefit to an FIA).

(190.) See supra notes 89-92 and accompanying text (explaining the Supreme Court's decision in VALIC).

(191.) See supra Part II.A.4 (explaining the insurance companies' investment use of consumers' FIA premiums).

(192.) See supra Part II.A.1 (explaining the principal guarantee of an FIA).

(193.) See id. (explaining the principal guarantee and its transfer of risk from the consumer to the insurer).

(194.) See SEC v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65, 71-73 (suggesting that insurance products must involve an underwriting of risks through guarantees).

(195.) See generally Marrion, supra note 5; Cohen, supra note 10. For example, consider the MGIR and death benefit features that come with an FIA.

(196.) See generally Marrion, supra note 5; Cohen, supra note 10.

(197.) See SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 208 (1967) ("The insurer is obligated to produce no more than the guaranteed minimum at maturity, and this amount is substantially less than that guaranteed by the same premiums in a conventional deferred annuity contract.").

(198.) At a minimum, the insurer guarantees the principal at the time of maturity.

(199.) See United Benefit, 387 U.S. at 209 n.12 (setting company's "guarantee by analyzing the performance of common stocks").

(200.) Guarantees can vary, but cannot go below a certain level due to nonforfeiture laws. See Scalia & Davis, supra note 9, at 11 (explaining that nonforfeiture laws require the insurer to guarantee the "lion's share" of the principal even if the consumer elects early withdrawal). The current Rule 151 Safe Harbor requires that products satisfy a particular jurisdiction's nonforfeiture laws. See Rule 151 Safe Harbor, 17 C.F.R. [section] 230.151(c) (2008) (requiring a product to "specify a rate of interest ... that is at least equal to the minimum rate required ... by the relevant no forfeiture law").

(201.) SEC v. Howey, 328 U.S. 293, 294 (1946).

(202.) Under the '33 Act, an "investment contract" is one type of security. See 15 U.S.C. [section] 78c(14) (2006) (the term security means any investment contract).

(203.) The Court has not concluded that the annuities do fall under the exemption either.

(204.) See generally Malone v. Addison, 225 F. Supp. 2d 743 (W.D. Ky. 2002).

(205.) SEC Rule Proposal, supra note 3, at 37,752-53; see also supra note 136 (explaining the SEC's attempt to back out of this argument while still claiming the argument's upside).

(206.) See SEC Rule Proposal, supra note 3, at 37,753 (suggesting that FIA complexities require more stringent regulation).

(207.) See generally id. (arguing that federal regulation is necessary despite the current state regulatory scheme).

(208.) Id. at 37,755.

(209.) Id.

(210.) Id.

(211.) See SEC Rule Proposal, supra note 3, at 37,755 (offering the results of a study that examined sales seminars that FIA sales agents commonly use to promote their products).

(212.) This would probably explain why the SEC seemed to abandon this argument at one point in its Final Rule. However, only pages later, the SEC returned to this argument in its Final Rule, citing effectiveness of regulation as a benefit of Rule 151A. See supra note 136.

(213.) See supra notes 208-11 and accompanying text (detailing the Rule Proposal's reliance on NASAA's reports).

(214.) NASAA, NASAA Survey Shows Senior Investment Fraud Accounts for Nearly Half of All Complaints Received by State Securities Regulators, http://www.nasaa.org/nasaa_newsroom/current_nasaa_ headlines/4998.cfm (last visited Jan. 25, 2010).

(215.) See id. (presenting results from a study on variable and fixed annuities).

(216.) See generally SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65 (1959) (holding that variable annuities should be regulated as securities and not annuities).

(217.) Gorman, supra note 48, at 15.

(218.) Id.

(219.) See Charles H.B. Braisted, State Registration of Securities: An Anachronism No Longer Viable, 78 Wash. U. L.Q. 401, 401-02 (2000) (describing NASAA as a "trade association" that lobbies on behalf of its members).

(220.) See Scalia & Davis, supra note 9, at 26 n.21 (analyzing the Rule Proposal's use of NASAA's publications).

(221.) Id. at 26.

(222.) Prior to presenting the Rule Proposal, the SEC held an "open meeting," which is akin to a public presentation of its findings and Rule Proposal.

(223.) Gorman, supra note 48, at 15.

(224.) Id. at 15-16.

(225.) NAIC.org, Closed Confirmed Consumer Complaints by Coverage Type 3, http://www.naic.org/ documents/cis_aggregate_complaints_by_coverage_types.pdf (last visited Nov. 8, 2008). The study refers to FIAs by the synonym "equity indexed annuities."

(226.) Id.

(227.) Each state has an insurance commissioner who is charged with overseeing products from the insurance industry, which includes FIAs. Gorman, supra note 48, at 19 n.28 (citing Kenneth Black, Jr. & Harold Skipper, 13 Life & Health Insurance 757-58 (2000)).

(228.) Id. at 19.

(229.) Elizabeth F. Browne, The Tyranny of the Multitude is a Multiplied Tyranny: Is the United States Financial Regulatory Structure Undermining U.S. Competitiveness?, 2 Brook. J. Corp. Fin. & Com. L. 369, 378 n.32 (2008).

(230.) SEC Final Rule, supra note 1, at 3161.

(231.) Id.

(232.) Id. at 3161-62.

(233.) Id. at 3162.

(234.) See Gorman, supra note 48, at 22-23 (charting each state's FIA regulations).

(235.) See id. at 21 ("State insurance commissioners actively enforce compliance with these sales protection and disclosure laws through supervisory systems....").

(236.) Scalia & Davis, supra note 9, at 21-22.

(237.) See id. (explaining the various provisions of the NAIC's model disclosure law); see generally NAIC Model Laws, Regulations and Guidelines 245-1, [section][section] 3-9 (2007) [hereinafter NAIC Model Laws] (putting forth the relevant provisions of the NAIC's Model Rules).

(238.) See NAIC Model Laws, supra note 237, at 254-1, [section] 1 (listing the various states and whether they have implemented the NAIC Model Rules).

(239.) See, e.g., N.Y. CLS Ins. [section] 3209 (McKinney 2008) (requiring certain disclosures pertaining to all significant features of an FIA contract).

(240.) See Cal Ins. Code [section] 789.10 (2005) (requiring that insurance agents planning to meet with senior citizens in their home must make disclosures relating to the purpose of their visit at least 24 hours in advance).

(241.) See Gorman, supra note 48, at 22-23 (offering a chart of all states' disclosure requirements, including the free look requirement).

(242.) Peter D. Santori, Selling Investment Company Shares Via an Off-The-Page Prospectus: "Leveling the Playing Field" or "Diminishing Investor Protection", 20 J. Corp. L. 245, 276 n.179 (1995); Cohen, supra note 10, at 45.

(243.) Federal law requires a similar free look provision for variable annuities. Cohen, supra note 10, at 45. However, the point is not that state regulation is superior to federal regulation, but rather that federal regulation is not any more comprehensive than state regulation.

(244.) See SEC Rule Proposal, supra note 3, at 37,768 (explaining the requirements for selling securities under federal regulation).

(245.) Id.

(246.) A "broker-dealer" is federally licensed to sell federally registered securities. J. Parks Workman, The South Carolina Uniform Securities Act of 2005: A Balancing Act Under a New Blue Sky, 57 S.C. L. Rev. 409, 431-32 (2006).

(247.) Norman S. Poser, Liability of Broker-Dealers for Unsuitable Recommendations to Institutional Investors, 2001 BYU L. Rev. 1493, 1494.

(248.) Id. at 1495.

(249.) See id. at 1496 (explaining the historical trajectory of suitability regulation within the securities markets).

(250.) See generally NAIC Model Laws, supra note 237, at 275-1, [section] 1-8.

(251.) Scalia & Davis, supra note 9, at 24.

(252.) NAIC Model Laws, supra note 237, at 275-1, [section] 6(A).

(253.) See id. [section] 6(B)(1)-(3) (requiring a reasonable effort to obtain the consumer's financial status, tax status, investment objectives and other appropriate information).

(254.) Id. [section] 6(D)(1)(a)-(b).

(255.) See Scalia & Davis, supra note 9, at 24 (citing a 2007 statement from FINRA supporting the NAIC Model Rules).

(256.) See Gorman, supra note 48, app. C (providing a list of states requiring the most stringent suitability practices); see, e.g., Fla. Stat. [section] 627.4544(4)(a) (2008) (requiring that the sales agent has an "objectively reasonable basis 'for believing that the recommendation ... is suitable for the senior consumer based on the facts disclosed by the senior consumer'").

(257.) See supra note 241 and accompanying text.

(258.) See Exec. Order No. 12,866, 58 C.F.R. [section] 190 (1993) (requiring federal agencies to make a cost/benefit analysis prior to promulgating Rules and regulations).

(259.) SEC Rule Proposal, supra note 3, at 37,770.

(260.) Competition within the FIA market could decrease because some current industry participants may elect to forego their sales of FIAs due to the high costs, leaving fewer market participants. See id.

(261.) Id.

(262.) Id.

(263.) Jack Marrion, The Proposed Rule Will Sock It to Index Annuity Distributors, Nat'l Underwriter, Aug. 4, 2008, available at http://www.lifeandhealthinsurancenews.com/ cms/nulh/weeklyissues/issues/2008/29/focus/l29cover2 [hereinafter Sock it to Indexed Annuity Distributors].

(264.) Scalia & Davis, supra note 9, at 25-27.

(265.) See id. at 26-27 (referring to the self-regulatory organization's requirements).

(266.) Id.

(267.) Id.

(268.) "Letter Type A" in response to the Rule Proposal (July 11, 2008), available at http:// www.sec.gov/comments/s7-14-08/s71408typea.htm [hereinafter Letter Type A].

(269.) Id.

(270.) Sock it to Indexed Annuity Distributors, supra note 263.

(271.) See generally Am. Equity Inv. Life Ins. Co. v. SEC, 572 F.3d 923 (D.C. Cir. 2009) (remanding the rule to the SEC).

(272.) The rule also seeks to overrule the previous Rule 151 which, according to the federal court in Malone v. Addison, 225 F. Supp. 2d 743 (W.D. Ky. 2002), exempted FIAs from federal securities regulation.

(273.) See supra notes 103-11 and accompanying text (providing a summary of Malone v. Addison).

(274.) See supra note 5 and accompanying text.

(275.) See supra Part III.E (addressing the potential for increased costs).

(276.) The industry has had much legal authority to rely on in determining that FIAs were not securities. The '33 Act's language clearly indicates that FIAs are not insurance products. A federal court has confirmed that interpretation. Two Supreme Court cases have offered holdings that classified certain annuities as securities, but the Court's tests were narrow enough that FIAs were not included. See supra notes 89-102 and accompanying text.

(277.) See SEC Rule Proposal, supra note 3, at 37,769 ("[W]e believe that there would be costs associated with the proposal.").

(278.) Letter Type A, supra note 268.

Matt Van Heuvelen, J.D. Candidate, 2010, University of Iowa College of Law. The author wishes to thank his parents, Wayne and Priscilla Van Heuvelen, for their unending support and encouragement. Many thanks as well go to Kevin Techau for aiding my efforts in writing this Note.
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