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RRGs grapple with vague application of securities laws.

The Liability Risk Retention Act of 1986 (RRA) and the Products Liability Risk Retention Act of 1981 were enacted by Congress to permit groups facing similar liability risks to form their own companies to provide liability insurance. In its attempts to promote the formation of risk retention groups, Congress eliminated regulatory obstacles by granting these groups broad exemptions from many state insurance regulations and certain state and federal securities law requirements. However, while the RRA specifically addresses the applicability of particular securities provisions, it ignores others.

Traditionally, insurance has been outside the scope of securities laws, as specified by an exemption for insurance policies under the Securities Act of 1933. New developments in the insurance industry, however, have blurred the boundaries between insurance and securities. As a result, it is important for anyone organizing a risk retention group to analyze its formation and operation in light of federal securities laws. It is especially important because of the growing interaction between insurance and securities and the failure of the RRA to address the applicability of the securities laws to risk retention groups.

Vague Provisions

Section 3904 of the RRA states that the ownership interests of members in a risk retention group will not be considered securities for purposes of state blue-sky laws. The section further states that the ownership interests of members in these groups will be considered exempted securities for purposes of the registration provisions of Section 5 of the 1933 securities act and Section 12 of the Securities Exchange Act of 1934. Such ownership interests will, however, be considered securities for the purposes of the anti-fraud provisions found in Section 17 of the 1933 act and Section 10 of the 1934 act. Provisions in these two acts could apply to the purchase or sale of membership interests in risk retention groups. Although the applicability of sections 17 and 10 is clear, failure of the RRA to address the application of the balance of the securities laws has led to great uncertainty.

Sections 17 and 10 render a risk retention group and its controllers liable for any misstatement of or failure to disclose a material fact in a transaction involving the sale or purchase of a membership. Liability may attach to the issuer and to directors, officers and incorporators involved in the sale of the membership. To assure potential members adequate disclosure, a risk retention group should comply with the disclosure requirements of a private placement or a registered offering, whichever applies to the particular group. For example, Regulation D, a safe harbor for private placements under the 1933 act, prescribes the disclosure requirements for certain private offerings. The requirements depend partly on the nature and number of prospective purchasers. If an offering is too large or does not qualify as a private placement, it should be treated as a public offering for disclosure purposes.

Aggrieved members of a risk retention group asserting a cause of action according to the federal anti-fraud provisions could recover the actual incurred damages through their purchase of a membership interest. Such damages could include an amount up to the risk retention group's coverage limits if the group fails to provide the coverage purchased. In addition, by participating in a particular risk retention group, a member may forfeit the opportunity to purchase insurance from other sources with more favorable lock-in rates.

Further, because liability insurance coverage is often available only on a claims-made basis, insureds are encouraged to remain with one company. Changing companies would require the purchase of tail coverage for protection from incidents which occurred prior to obtaining the new coverage. These costs could be considered damages that resulted from purchasing a membership interest in a risk retention group. In addition to the liability provided by the federal anti-fraud provisions of Section 17 of the 1933 act and Section 10 of the 1934 act, state common law fraud provisions may also apply.

Although sections 17 and 10 clearly apply to the sale of interests in risk retention groups, it is unclear if other anti-fraud provisions in the securities laws are applicable. Section 12(2) of the 1933 act states that anyone who offers to sell or sells a security using a prospectus or oral communication containing a material omission or false statement is liable to the purchaser of that security. While the liability provisions of Section 12(2) appear similar to the anti-fraud provisions of sections 17 and 10, Section 12(2) may be a more attractive remedy for disgruntled purchasers.

Sections 17 and 10 require a plaintiff to prove a specific intent to deceive or defraud as part of his or her claim. However, Section 12(2) eliminates the requirement to prove knowledge of wrongdoing and places the burden on the defendant to prove that he or she acted with reasonable care. The remedy available under Section 12(2) in other securities cases is often the rescission of the member's interest, but it could include actual damages assessed under the federal anti-fraud provisions. Thus, except for a potentially shorter statute of limitations (one year from the date fraud was or should have been discovered, but not more than three years from the date of sale), application of Section 12(2) to risk retention groups would arguably strengthen the protection provided by sections 17 and 10.

No-Action Requests

The RRA specifically addresses the application of the registration and federal anti-fraud provisions to interests in risk retention groups. The failure of the RRA to address the rest of the securities laws poses numerous questions and leaves many issues unresolved. Only some of those issues have been clarified by the Securities and Exchange Commission in its responses to no-action requests. Unless the act is clarified, resolution of these issues may only come about through litigation.

In order to gather some measure of comfort, risk retention groups have engaged in the expensive and time-consuming process of seeking no-action advice from the SEC on the applicability of securities laws. These requests have dealt with the availability of the RRA's exemption from the securities registration provisions, as well as the applicability of broker-dealer registration, and advertising and solicitation constraints.

Fledgling risk retention groups that request a no-action position from the SEC do so on the issue of whether their particular group qualifies for the RRA's exemption from the registration requirements of the securities laws. Although the RRA clearly states that such exemptions are available for a risk retention group, it does not contain a mechanism that allows a group to be sure it meets all the requirements. Thus, groups with a slightly different organizational structure may not feel comfortable relying on the RRA's securities exemption without regulatory assurance that such reliance is permissible.

In addition, some risk retention groups may offer and sell memberships before they are technically formed. The RRKs exemption from the registration provisions of the securities laws applies to ownership interests in a risk retention group. Because the RRA is unclear on the point that once the group is formed the securities exemption will apply retroactively to such sales, some groups may not want to proceed without SEC advice. If the RRA's intention was to require technical compliance with certain requirements prior to the offer or sale of memberships, this intent should be clarified.

The securities laws contain many other provisions which, if membership interests are construed as securities, could arguably apply to risk retention groups. Section 15 of the 1934 act requires brokers and dealers selling securities to register with the SEC and comply with several substantive regulations. Because the RRA is silent on the issue, it may be argued that the membership interests in the risk retention group are securities. Therefore, the risk retention group itself or the agents placing insurance with the members of the group should be required to register with the SEC as securities brokers.

The SEC, however, has indicated that it would not act if sales of membership interests in the groups, or common stock evidencing such membership interests, were completed without registration under Section 15. Although the SEC did not accept the arguments that the ownership interests of those groups did not constitute securities, it did note that the interests were not characteristic of securities.

The SEC's failure to take the position that promoters and others selling membership interests in risk retention groups are categorically exempt from the provisions of Section 15 is disturbing. Again, because these no-action letters raise the possibility that under different factual circumstances the broker-dealer registration provisions could apply to the sale of membership interests in risk retention groups, groups desiring reassurance on this point will have to seek their own no-action letters from the SEC.

Similarly, it is unclear whether certain rules imposing advertising and solicitation constraints on promotional activities are applicable to risk retention groups. An implementation report on the RRA prepared by the U.S. Department of Commerce in September 1987 noted the ambiguities in the RRA's treatment of the application of the securities laws: "The National Association of Insurance Brokers (NAIB) suggests that the exemption is unclear regarding whether a group must be formed before sales of shares begin and who is considered a promoter. Similarly, advisory letters received from the Securities and Exchange Commission apparently indicate that a group may have to use a licensed broker-dealer in some sales. The NAIB recommends that those selling ownership interests in risk retention groups should be specifically exempted from a requirement to be a licensed securities broker-dealer and specifying that all preformation promotional activities are covered by securities law exemptions."

The SEC has, in one no-action letter, indicated that compliance with the restrictions on promotional activities found in rules 134 and 135 under the 1933 act was not necessary in connection with the sale of the membership interests in that risk retention group. The SEC noted that its decision was based on the facts presented and did not purport to make a more general statement on the applicability of the securities laws to risk retention groups. For many risk retention groups, the SEC's positions on these no-action letters may be comforting. However, an explicit acknowledgment that the securities laws, with the exception of sections 17 and 10, are inapplicable to risk retention groups would be more desirable.

Post-Formation Issues

Although many of the federal securities law questions arise during the organization of a risk retention group, once the group is formed, some issues remain. For example, because offering membership interests in risk retention groups is periodic or continuous, the offering documents should be revised when changes occur in the operations or financial condition of the group. In this respect, the sale of membership interests is like a shelf registration of securities under Rule 145 of the 1933 act, whereby an issuer can register securities that it contemplates offering over a two-year period. Such issuers are required to review their business and financial conditions to determine whether a fundamental change in the information contained in the initial offering material has occurred. In addition, the information should be updated if it is more than 16 months old. If any such changes have taken place, or updating financial information is necessary, the core disclosure documents must be revised or supplemented. The same anti-fraud concerns previously discussed regarding the initial offering documents are also applicable in this context.

It is unclear whether, or to what extent, a risk retention group should be guided by securities laws dealing with the ongoing operations of a group. For example, the 1934 act and its rules contain an extensive regulation of the solicitation of proxies from shareholders and require the submission of an annual report to shareholders. The solicitation of proxies is governed by Section 14 of the 1934 act, which applies to any security registered according to Section 12. Because ownership interests in risk retention groups are considered exempted securities for purposes of the registration provisions of Section 12, the federal proxy rules are inapplicable. Groups, however, are not exempt from applicable state insurance requirements regarding the solicitation of proxies. Some risk retention groups may choose to include a proxy in a member's initial application for insurance, thus eliminating the need for annual solicitations. Again, the SEC rules may prove useful for a risk retention group issuing an annual report and soliciting proxies from its members.

Finally, some risk retention groups have agreed to repurchase membership interests under particular circumstances such as rescission offers, voluntary termination of coverage by an insured and involuntary terminations of coverage. Rule lOb-6 of the 1934 act prohibits an issuer of securities from purchasing its own securities during their distribution. Although the rule applies primarily to registered distributions, it may also apply to unregistered offerings. Because a risk retention group is always offering new membership interests, it may exceed Rule lOb-6 prohibitions if it is obligated to or voluntarily repurchases other interests. The SEC has issued a release on the application of Rule 10b-6 to shelf registrations and has a system of cooling-off periods during which the issuer may not offer its securities for sale. This system is probably not feasible for most risk retention groups.

Clarification Needed

The current scheme governing the formation of risk retention groups is inadequate because of a seeming lack of coordination between Congress and the SEC. The RRA does not address the application of many aspects of the federal securities laws, with the exception of the registration and anti-fraud provisions. The SEC, when faced with no-action requests, has issued letters that are generally favorable to risk retention groups, but has been unwilling to state that such groups are exempt from the applicability of the securities laws other than the antifraud provisions.

Ideally, the ambiguity should be jointly resolved by Congress and the SEC. The securities laws should not be imposed on risk retention groups for several reasons. First, the legislative history of the RRA and its predecessor, the Products Liability Risk Retention Act of 1981, indicate that comprehensive regulation by the SEC was not contemplated. Congress intended that the securities laws be generally inapplicable to risk retention groups. Second, there are strong policy reasons why the protection of the federal securities laws is unnecessary. Congress deemed the goals and purposes of the RRA important enough to exempt risk retention groups from many of the individual state insurance regulations. It would be inconsistent for Congress to apply the federal securities law regulatory scheme to risk retention groups, and even more unlikely that Congress would assume the application of those laws without specific reference.

In addition, risk retention groups are sufficiently regulated so that the additional protection afforded by government securities laws is unnecessary. Although these groups are exempt from many state insurance regulations, they remain subject to many regulations promulgated by both the state of domicile and the states where the group writes coverage. Finally, the securities laws should not be imposed on risk retention groups because a legal analysis of the membership interests concludes that those interests are not securities within the federal securities laws definition. A membership interest in a risk retention group, whether or not evidenced by stock, is usually not purchased for investment purposes. Rather, membership in the group is a condition of obtaining insurance coverage. Application of certain tests set forth by the Supreme Court to help determine whether particular interests constitute securities should conclude that membership interests in risk retention groups are not securities. In similar contexts involving membership interests in mutual insurance companies and risk pooling trust plans, the SEC has issued no-action responses indicating that those interests would not constitute securities.

Analysis Needed

In enacting the RRA, Congress attempted to promote the formation of self-insurance groups to increase competition within the insurance industry and make liability insurance available at affordable rates to groups facing similar liability risks. It is unlikely that Congress intended to put risk retention groups at a competitive disadvantage by making the federal securities laws applicable to those groups.

The protection afforded by the RRA, the various state insurance laws and the anti-fraud provisions of Section 17 of the 1933 act and Section 10 of the 1934 act provide sufficient regulation of these groups. However, without a determination that the federal securities laws, excluding sections 17 and 10, do not apply to risk retention groups, such groups are well-advised to analyze their formation and operation in light of the federal securities laws.
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Title Annotation:risk retention groups, Liability Risk Retention Act of 1986
Author:Hennessy, Colleen M.; McCurdy, Kay W.
Publication:Risk Management
Date:Jul 1, 1990
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