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OTTO v. VARIABLE ANNUITY LIFE INS. CO.

April 11, 1985

BEVERLY J. OTTO, INDIVIDUALLY AND ON BEHALF OF ALL OTHERS SIMILARLY SITUATED, PLAINTIFF,
v.
VARIABLE ANNUITY LIFE INSURANCE COMPANY, A STOCK LIFE INSURANCE COMPANY ORGANIZED UNDER THE LAWS OF THE STATE OF TEXAS, CHARLES T. BAUER, MORTIMER M. CAPLIN, HENRY CHAUNCEY, HARRY C. COPELAND, JR., W. THOMAS FIQUET, FREDERICK M. GLASS, GRINNEL MORRIS, ROY T. PARKER, JR., ROBERT S. PHILLIPS, MICHAEL E. PUYANS, W. DAWSON STERLING, BENJAMIN N. WOODSON, PHILIP G. DAVIDSON III, ANDREW DELANEY, JOE F. FLACK, RICHARD H. HANNEMAN, HAROLD S. HOOK, MARDEN MILLER, JOHN J. PLUMB, GEORGE F. REED, ROBERT L. BALDWIN, STEPHEN D. BICKEL, TERRENCE J. CONLAN, JOE D. HEUSI, JOHN D. HOGAN, WILLIAM B. PARDUE, WILLIAM C. PHELPS, MICHAEL J. POULOS, ROBERT O. PURCIFULL, DIANE G. D'AGOSTINO, AND GREGORY C. WILCOX, INDIVIDUALLY VARIABLE ANNUITY LIFE INSURANCE COMPANY SEPARATE ACCOUNT ONE, AND AMERICAN GENERAL CORPORATION, DEFENDANTS.



The opinion of the court was delivered by: Aspen, District Judge:

  MEMORANDUM OPINION AND ORDER

Plaintiff Beverly J. Otto ("Otto"), on behalf of herself and others similarly situated, brings this suit against the Variable Annuity Life Insurance Company ("VALIC") and certain affiliated companies and named directors of VALIC, alleging, inter alia, violations of the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq.; the Employee Retirement Income Security Act of 1974 ("ERISA"), 29 U.S.C. § 1001 et seq.; and the Racketeer Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. § 1961-1968. Otto essentially claims that the defendants have unlawfully failed to disclose to investors in VALIC's fixed annuity program the manner in which interest is calculated on their deposits, as well as the method by which investors can transfer their funds so as to maximize their rate of return. On March 15, 1984, the Court granted Otto's motion for class certification, permitting her to represent the class of all Illinois investors who participated in VALIC's fixed annuity program between October 17, 1975, and August 2, 1982. Presently before the Court is defendants' motion to strike and dismiss and for summary judgment. For the reasons set forth below, defendants' motion is granted.

Count I

Defendants offer several reasons why the complaint's securities fraud count fails to state a claim upon which relief can be granted and why defendants are entitled to summary judgment on that count as a matter of law. We need address only one of these reasons, defendants' assertion that the fixed annuity is not a security.

Defendants argue that VALIC's fixed annuity is not within the scope of the Securities Exchange Act of 1934 because it falls into the statutory exemption for "any insurance or endowment policy or annuity contract or optional annuity contract" issued by a regulated insurance company. 15 U.S.C. § 77c(a)(8).*fn1 Otto, on the other hand, argues that VALIC's fixed annuity should be characterized as an "investment contract," one type of security defined in 15 U.S.C. § 78c(a)(10).*fn2 Although the term "investment contract" is a catch-all to bring within the securities acts various interests that have the functional attributes of stock and other formal securities but are not so denominated, Peoria Union Stock Yards Company Retirement Plan v. Penn Mutual Life Insurance Co., 698 F.2d 320, 324 (7th Cir. 1983), we agree with defendants that the fixed annuity is more properly viewed as an insurance product than as an investment contract.

The contract under which Otto and the other class members became participants is designed for annuity purchase plans adopted by public school systems and certain tax-exempt organizations pursuant to Section 403(b) of the Internal Revenue Code, 26 U.S.C. § 403(b). Under the contract's terms, participants may designate a portion of their salaries for deposit into either a variable or a fixed annuity account, and those amounts (up to a statutory maximum) are excluded from the participants' gross income for the year.

Since 1968, VALIC's variable annuity has been funded through Separate Account One, a diversified open-end management investment company registered under the Investment Company Act of 1940. Funds contributed by participants are segregated from VALIC's other assets and are invested primarily in a diversified portfolio of common stocks and other equity-type investments. The participants bear all the investment risks with this annuity; neither interest nor the principal contributed by the participants is guaranteed by the company. The participants' profits thus depend solely upon the expertise and investment success of those who invest the funds in the Separate Account.

The fixed annuity, the subject of this lawsuit, operates quite differently. Participants' contributions become a part of the company's general assets.*fn3 The stated primary objective of the fixed annuity is to provide insured retirement stability by long-term accumulation of funds through compound interest. VALIC bears the investment risk, because it guarantees the return of both principal and a minimum of 4% compound annual interest for the first ten years of participation and 3 1/2% interest thereafter. Interest above the minimum level may be paid in the discretion of VALIC's board of directors.

Otto asserts that the status of VALIC's fixed annuity as a security is settled "beyond all question" by three cases: SEC v. Variable Annuity Life Insurance Co. of America, 359 U.S. 65, 79 S.Ct. 618, 3 L.Ed.2d 640(1959); SEC v. United Benefit Life Insurance Co., 387 U.S. 202, 87 S.Ct. 1557, 18 L.Ed.2d 673 (1967); and Peoria Union Stock Yards. These cases do shed some light on this issue, but they do not support, much less compel, the conclusion Otto reaches.

The Supreme Court decided long ago that a variable annuity offered by VALIC was a security. VALIC, 359 U.S. at 71, 79 S.Ct. at 622.*fn4 In doing so, the Court distinguished traditional fixed annuities from the more recently evolved variable annuities. Id., 359 U.S. at 69, 79 S.Ct. at 621. Unlike their predecessors, variable annuities were to be treated as securities rather than insurance products, in large part because they placed the entire investment risk on the annuitant. "For in common understanding `insurance' involves a guarantee that at least some fraction of the benefits will be payable in fixed amounts." Id., 359 U.S. at 71, 79 S.Ct. at 622.

The Supreme Court discussed the relationship between annuities and the federal securities laws further in United Benefit. That case involved a deferred, or optional, annuity plan called a "Flexible Fund Annuity" contract, under which the purchaser agreed to make certain annual contributions until a specified maturity date. The insurance company invested most of the Flexible Fund contributions in common stocks, with the object of producing capital gains as well as an interest return. "Instead of promising to the policyholder an accumulation to a fixed amount of savings at interest, the insurer promise[d] to serve as an investment agency and allow the policyholder to share in its investment experience." United Benefit, 387 U.S. 202, 208, 87 S.Ct. 1557, 1560. Upon maturity the purchaser could either withdraw his contributions, plus the earnings that had accumulated through the insurer's investment of those contributions, or use them to purchase an annuity from the company. Whatever his choice, the purchaser was guaranteed a low minimum value (with no interest component) at maturity.

The Court found that the accumulation portion of this annuity plan was an investment contract rather than an insurance product. Although the cash value guarantee reduced somewhat the investment risk of the purchaser, this was not enough. The Court stated that "`[t]he test . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.'" Id., 387 U.S. at 211, 87 S.Ct. at 1562, quoting SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 352-53, 64 S.Ct. 120, 124, 88 L.Ed. 88 (1943). The Flexible Fund was "considered to appeal to the purchaser not on the usual insurance basis of stability and security but on the prospect of `growth' through sound investment management." United Benefit, 387 U.S. at 211, 87 S.Ct. at 1562. Given the plan's pitch to growth through professionally managed investment, the Court deemed it fair to apply the securities laws to it. Id.

VALIC's fixed annuity differs significantly from the plans in these two Supreme Court cases. VALIC bears the investment risk, guaranteeing the return of the participants' contributions plus interest. Moreover, the economic inducement of the fixed annuity is indeed the "usual insurance basis of stability and security" rather than growth through investment. The company's literature clearly emphasizes the different objectives of the variable and fixed annuities: the former is "long-term capital growth," which the latter is the more secure "long-term accumulation of funds for retirement through compound interest." See, e.g., VALIC's Owner's Manual, Exhibit B to Otto's complaint. The stability of the fixed annuity was apparent to Otto, who stated that she chose this annuity instead of the variable annuity because she did not like "the fluctuating rates" and wanted "a more conservative investment." Otto deposition, p. 25.*fn5 Accordingly, VALIC's fixed annuity is distinguishable from the annuities which the Supreme Court has found to be within the reach of the securities laws.

Nor does the Seventh Circuit opinion in Peoria Union Stock Yards bolster Otto's claim that the fixed annuity should be treated like a security. That case dealt with a "group deposit administration annuity contract" sold by an insurance company to pension trustees. The insurance company guaranteed interest payments (at a rate declining from 7 1/2%, to 3 1/2%) on contributions made during the first three years of the contract, but it made no guarantee on later contributions. All the contributions, however, were to be credited with whatever investment income the insurance company could realize, less certain modest administrative charges. Thus, the Seventh Circuit found that the insurance company bore even less of the investment risk than did the company in United Benefit, and that any profits of the enterprise were due solely to the investment efforts of the insurance company. Peoria Union Stock Yards, 698 F.2d at 325. This plan is thus distinguishable from VALIC's fixed annuity in the same way as the ...


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