Given the extraordinary growth of the U.S. life settlement industry over the last decade, it is not surprising to find increased attention to and scrutiny of life settlements by academicians, the media and legal enforcement authorities including, among others, state and federal securities regulatory and self-regulatory organizations. The securities laws regulators argue that investments in all forms of life settlement transactions involve the sale of securities and that the full spectrum of security laws applies; for the most part they may be right.
A life settlement transaction is the sale of an in-force life insurance policy by the owner for an amount more than the policy’s cash surrender value and less than the face or death benefit payable under the policy. Exhibit 1 shows a functional diagram of the transaction “players” in a life settlement transaction. In the context of this article, a life settlement transaction involves the sale of an in-force, non-variable life insurance policy by the owner of the policy (which may or may not be a life settlement provider) to a “passive” investor. A “passive” investor for these purposes is an investor who, although perhaps sophisticated, experienced and capable of bearing the economic risk of the investment in a life settlement, does not directly perform or cause to be performed the medical due diligence with respect to the insured–including performing the life expectancy analysis and an actuarial valuation of the policy–and does not negotiate directly with the owner, determine premium payment optimization, arrange for the payment of premiums and tracking of the life status of the insured, or file the death benefit claim under the policy. A life settlement broker typically represents the owner of the life insurance policy in the sale of the policy. For purpose of this analysis, the focus is on the activities of the life settlement provider that buys or arranges for the purchase of the policy and “packages” the sale for the benefit of the passive investor by conducting extensive pre-sale activities and bundling post-sale services in the product purchased by the investor.
In discussing the pertinent securities-related issues surrounding life settlements, there are three fundamental questions which need to be addressed:
* Does the sale of the life insurance policy involve the sale of a “security” under the Securities Act of 1933, as amended (the “1933 Act”)?
* Do the “registration” requirements under the 1933 Act apply?
* Do sales activities in connection with the sale of the life insurance policy trigger any broker-dealer registration requirements under the Securities Exchange Act of 1934, as amended (the “1934 Act”)?
LIFE SETTLEMENT TRANSACTION AS A SALE OF A “SECURITY”
Does a life settlement transaction involving the sale of a single life insurance policy to a single, passive investor involve the sale of a security for federal law purposes? In all probability, the transfer of ownership of an entire policy (as well as fractionalized interests in a policy) to a “passive” investor does involve the sale of a security. Let’s work our way up to it.
No one can argue anymore that the initial sale (i.e., issuance) of a variable life insurance policy by a life insurance company (and its investment company affiliate which establishes the separate account into which investments made under the policy are made) does not involve the sale of a security, fractionalized or not. From this, it easily follows that the resale of a variable life insurance policy into the secondary investment market in a life settlement transaction also involves the sale of a security.
In S.E.C. vs. Mutual Benefits Corporation, 403 F.3d 737 (11th Cir. 2005), the federal Circuit Court for the 11th Circuit Court of Appeals held that the sale of life insurance policies in viatical settlement transactions involved the sale of “securities” for federal purposes. In that case, the Circuit Court of Appeals refused to follow the Life Partners case, which the United States Court of Appeals for the D.C. Circuit decided nine years earlier (S.E. C. vs. Life Partners, 87 F.3d 356 (D.C. Cir. 1996)) and held to the contrary. Neither case distinguished between fixed and variable policies underlying the life settlement transaction, and the focus was on fractionalized policies. Although there were some whole policies sold directly to individual investors in the Mutual Benefits case, whether the policies were fractionalized was not a core feature of that case. The Life Partners decision was roundly criticized by legal scholars and, more importantly, by state security commissioners. In fact, in the wake of that decision many states amended their own state security or blue sky statutes specifically to define, as a security, life and viatical settlement investments.
Established United States Supreme Court precedent defines the term “investment contract,” one of the enumerated terms under the statutory definition of a security in the 1933 Act, to be an investment in a common enterprise with the expectation of profit derived solely from the efforts of a promoter or others (S.E.C. vs. W.J. Howey Co., 328 U.S. 293 [1946]).
Other cases define whether the expectation of profit must be solely or predominantly from the efforts of the promoters, with “predominantly” winning out, and whether the common enterprise concept requires a pooling of investor funds (horizontal commonality) or just the relationship between the promoter and the investor (vertical commonality), with vertical commonality–the least restrictive test–prevailing, at least in the Eleventh Circuit in the case of investments in viatical settlements under the Mutual Benefits case.
In Life Partners, the Court held that because the efforts of the promoter were principally pre-sale, (i.e., securing the policies, packaging the policies, conducting the medical examinations (or at least studying the medical histories), evaluating life expectancies, pricing the investment to be made by the purchasers, preparing all of the contractual documents, etc.) and there were very few post-sale activities, no “security,” for federal securities law purposes, was involved.
The Mutual Benefits decision rejected that notion. The Court held that the Howey test did not require a distinction between a promoter’s pre-sale and post-sale activities and that significant pre-purchase managerial activities undertaken to ensure the success of the investment may also satisfy the “solely on the efforts of the promoter or a third party” prong of the Howey test.
However, there are no published federal cases that examine the question of whether the sale of an entire fixed, non-variable life insurance policy to a single investor, as opposed to fractionized interests in a life insurance policy, constitutes the sale of a “security.” It is possible a court might conclude that the sale of the entire life insurance policy, in contrast to the sale of a fractionalized interest in the life insurance policy, does not involve the sale of a “security,” but that would be an unexpected result in today’s regulatory environment.
In Life Partners, the court did comment in dicta that, “[P]resumably, a firm might also buy insurance policies for its own account or act as an agent, matching a single investor with a terminally ill insured, without running afoul of the security laws. That is not how [Life Partners] does business, however” (87 F.3d 536 at 539). At the time Life Partners was argued in 1995, the position of the SEC was to the effect that a straight viatical settlement was not a security. By that, the SEC meant that the naked sale of the life insurance policy, without more, did not give rise to concerns under the federal security laws. What did raise those concerns for the SEC, however, was whether the sale of the life insurance policy “as packaged, offered, sold and administered” crossed the line. The SEC did not prevail on that issue in Life Partners, but it was resoundingly successful ten years later in Mutual Benefits.
There have been state court decisions where the courts concluded that matching single policies to single investors did involve the sale of an investment contract and thus a security under a Howey analysis. See, e.g., Marshall L. Peaslee vs. Accelerated Benefits Corporation, et al., 818 N.E.2d (Ind. Ct. App. 2004); Siporin, vs. Carrington, et al., 200 Ariz. 97 (Ariz. Ct. App. 2001). Numerous other federal district court decisions also conclude that life settlement investment programs are deemed to involve the sale of securities under federal law. See, e.g., Wuliger vs. Christie, 310 ESupp.2d 897 (N.D. Ohio, 2004) and cases cited therein.
APPLICATION OF REGISTRATION REQUIREMENTS
The next question is, assuming the sale activities involve the sale of a “security,” do the registration requirements of the 1933 Act apply?
Unless the sale involves either an exempt security or is an exempt transaction under Sections 3 and 4 of the 1933 Act, the registration requirements apply.
There is an untested argument that the sale of an entire fixed, non-variable life insurance policy to a single investor is the sale of an exempt security under Section 3(a)(8) of the 1933 Act. Simply stated, that section exempts the sale of a life insurance policy issued by an insurance company.
Section 3(a)(8) of the 1933 Act Provides
Section 3 Exempt Securities Except as hereinafter expressly provided, the provisions of this title shall not apply to any of the following classes of securities:
(8) Any 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;
It would be “aggressive” to rely on this exemption, however, primarily because the law is relatively clear that the sale of a fractionalized policy is a security, and the sale of an interest in a pool of policies is a security, so why shouldn’t the secondary sale of a single policy to a single investor also involve the sale of a security? In fact, in Life Partners, in the context of its life settlement fractionalized program, the court rejected the defendants’ argument that the Section 3(a)(8) exemption should apply. See 87 F.3d at 542. The distinction between fractionalized and non-fractionalized might be considered by a court to be just as artificial as the pre vs. post sale promoter efforts rejected in Mutual Benefits. One of the important issues under this exemption is whether the purchaser is at investment risk or simply financial/solvency risk. (See the Variable Life Insurance case cited below.) Here, it could be argued that there is investment risk because the purchaser must track the insured and pay additional premiums, and if the insured outlives the expected life expectancy projection used in pricing the policy, the investment return will decline.
The United States Supreme Court has found that variable-rate annuities are securities for purposes of the 1933 Act (Securities Exchange Commission v. Variable Life Insurance Co., 359 U.S. 65 [1959]). Although the Supreme Court has not decided whether a variable annuity or a life insurance policy with a variable annuity feature is a security under the 1933 Act, in light of its finding in Variable Lift Insurance, supra, it is probable that the Court would find it to be one.
Nevertheless, the sale may still be exempt from the registration requirements of the 1933 Act as an exempt transaction under Section 4 of the 1933 Act.
Section 4–Exempted Transactions
The provisions of section 5 [registration] shall not apply to–
2. transactions by an issuer not involving any public offering.
6. transactions involving offers or sales by an issuer solely to one or more accredited investors, if the aggregate offering price of an issue of securities offered in reliance on this paragraph does not exceed the amount allowed under section 3(b), if there is no advertising or public solicitation in connection with the transaction by the issuer or anyone acting on the issuer’s behalf, and if the issuer files such notice with the Commission as the Commission shall prescribe.
For either of these two exceptions to the registration requirements under Section 5 of the 1933 Act to apply, it must be concluded that a life settlement company is an “issuer” for purposes of this analysis.
Section 2.4 of the 1933 Act defines “issuer” as “every person who issues or proposes to issue any security…”
In many respects, the typical life settlement transaction involves much more than simply the sale of the underlying life insurance policy. More often than not, the issues for the security to the “passive” investor includes not only the cost of the underlying life insurance policy paid to the seller but also commissions and other remuneration and reimbursements for those involved in reviewing, pricing and structuring the transaction; several years of annual premiums; tracking and administration fees for payments of annual premiums and filing death benefit claims; and other related charges. In other words, the “security” represents the totality of the arrangement which includes pre-sale and post-sale activities that are bundled with the sale of the life insurance policy.
In the absence of clear case law, it may be argued that a court, when presented with all of the facts and circumstances, would conclude, by virtue of the sales contract as the investment contract and all of the activities of a life settlement company in performing medical due diligence, reviewing the life insurance policy, conducting the actuarial/life expectancy analysis, negotiating pricing with the life settlement broker, etc., that such life settlement company would be an “issuer,” even though it may not take title to and then transfer the policy to the investor.
Assuming that a life settlement company is the issuer, then, so long as there is no advertising or public solicitation in connection with the transaction by the issuer or anyone acting on the issuer’s behalf, the “investor” is sophisticated, is provided all of the information that it requests, and represents that it is acquiring the policy for investment purposes only and not with a view to a resale of all or any part thereof, then the sale to the investor would be an exempt transaction, and the registration requirements of Section 5 of the 1933 Securities Act would not apply.
Regulation ED promulgated by the Securities Exchange Commission (the “SEC”) under the 1933 Act provides a “safe harbor” for the private offering exemptions. A life settlement company may consider compliance with Rule 506 of that regulation, which, among other things, requires (assuming a life settlement company does not want to prepare and deliver a prospectus-like disclosure document to interested investors) that the investor be “accredited” (which relates principally to the amount of an individual’s net worth or income, among other things), is sophisticated and able to bear the financial risk associated with the investment, is provided with access to the information relevant to the investment, and acknowledges in writing the investor’s investment intent.
In Life Partners, the defendants argued that, in the alternative, if the court concluded that the Life Partners’ programs did involve the sales of securities, the programs could be modified to come within the safe harbor provided by Rule 506. Because the court concluded that the Life Partners programs did not constitute securities subject to the federal securities laws, it expressly did not reach that alternative argument.
APPLICATION OF THE ANTI-FRAUD PROVISIONS UNDER THE 1934 ACT
Even if the 1933 Act registration requirements do not apply, that does not free a life settlement company from exposure to potential anti-fraud liability under the 1934 Act in connection with the purchase or sale of a security. This is where the defendants in Mutual Benefits ran into trouble.
Rule 10b-5–Employment of Manipulative and Deceptive Devices
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
There is no safety net, no safe harbor provision for avoidance of potential Rule 10b-5 liability. Consequently a life settlement company should provide complete disclosure and candor with respect to the investment opportunity that would include all of the risk factors attendant with the investment, background information on the life settlement company and its principals, detailed information on post-sale responsibilities of the investor (tracking, payment of premiums, etc.) if any, fees payable to the life settlement company and others associated with the transaction, etc., and complete access by the investors to information about the life settlement company, the policy and access to the management of the life settlement company for questions about the program.
APPLICATION OF BROKER DEALER REGISTRATION REQUIREMENTS UNDER SECTION 15 OF THE 1934 ACT
The third question is whether a life settlement company might trigger any of the broker-dealer registration requirements under federal or state statutes.
The short answer is yes, and it does not matter that the life settlement company is also the “issuer.” It can be both the issuer and the broker in the transaction, as odd as that may sound.
Who is a “broker” from the perspective of the SEC?
Section 3(a)(4)(A) of the 1934 Act defines a “broker” broadly as:
any person engaged in the business of effecting transactions in securities for the account of others.
A person who executes transactions for others on a securities exchange clearly is a broker; that’s an easy one, but other examples may not be so clear cut.
Investment advisers and financial consultants may qualify; certainly persons who market or effect transactions in insurance products that are securities, such as variable annuities, or other investment products that are securities, are required to register; and persons who effect securities transactions for the account of others for a fee, even when those other people are friends or family members, are also required to register.
In order to determine whether any of these individuals (or any other person or business) is a broker, the SEC looks at the activities that the person or business actually performs.
Does the person participate in important parts of a securities transaction, including solicitation, negotiation, or execution of the transaction?
Does the person’s compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction?
A “yes” answer to any of those questions indicates that a person may need to register as a broker with the SEC and obtain the appropriate license from the National Association of Securities Dealers (”NASD”).
This is what the NASD may have intended when it issued, in August 2006, a Notice to Members (Notice to Members 06-38) addressing “Member Obligations with Respect to the Sale of Existing Variable Life Insurance Policies to Third Parties” and concluded:
“[E]ntities participating in the sale and marketing of interests in life insurance policies, variable or not, for investment purposes may trigger broker-dealer registration requirements under the Securities Exchange Act of 1934.”
APPLICATION OF STATE SECURITY LAWS
As mentioned above, many states amended their security laws after the Life Partners case specifically to include investments in life settlement transactions within the definition of a security for state blue sky law purposes. This article does not generally address the issue of whether the sale of an in-force life insurance policy is a sale of a security for state law purposes, including, especially, those states that have amended their definition of security to include a life settlement contract. See, e.g., OCGA §10-5-2(a)(26).
However, under Section 18 of the 1933 Act, if a security is a “covered security” that, generally speaking, is an exempt security under Section 3 or is sold in an exempt transaction under Section 4 of the 1933 Act, a state may not require registration of that security under the state registration requirements. That means if a life settlement company carries out an investment transaction as a Section 4(2) issuer transaction or one under the safe harbor of Rule 506 of Regulation D, as described above, no state may lawfully require such life settlement company, as the issuer, to file any pre-sale report or registration documentation. However, that does not exempt the transaction or the life settlement company from the state anti-fraud provisions or the state broker-dealer/salesman registration/licensing requirements.
CONCLUSION
In summary, the sale of the entire interest in an in-force life insurance policy to a passive investor may very well involve the sale of a security. The sale can be structured so that it is exempt from the registration requirements of state and federal law. However, the state and federal anti-fraud provisions will apply to the transaction, and any person effecting the sale, particularly if compensated on the basis of the size of a successful sale, might be required to register with the SEC (and the applicable state) as a broker-dealer and be licensed as a security salesperson by the NASD.