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Otto v. Variable Annuity Life Insurance Co.


April 15, 1987


814 F.2d 1127. Appeals from the United States District Court for the Northern District of Illinois, Eastern Division, No. 82 C 4762, Marvin E. Aspen, Judge.

Bauer, Chief Judge, Cudahy and Ripple, Circuit Judges.

Author: Cudahy


CUDAHY, Circuit Judge.

Following the issuance of our opinion in this case, the defendant, Variable Annuity Life Insurance Company ("VALIC"), filed a motion to modify the opinion, and the plaintiff, Otto, filed a petition for rehearing. In its motion to modify the opinion, VALIC for the first time informed this court that it claimed to have the right to alter, at its unfettered discretion, the interest "bands" paid on past contributions. Earlier, both before the district court and this court, VALIC had claimed only that it had the discretion to declare the excess interest rate to be paid on new deposits. VALIC emphasized that these discretionary changes in the excess interest rate affected only current deposits and that past deposits would continue to earn the interest rate in effect at the time the deposit was made:

Like virtually all of its competitors at that time, VALIC employed the "new money" or "banding" method for crediting excess interest to the fixed annuity account; i.e., the excess interest rate set by the Board of Directors was paid on deposits made during that particular period. Subsequent fluctuations in the excess rate did not affect a participant's past contributions. Each deposit stayed in its "band," and continued to draw interest at the rate in effect when the deposit was made.

Defendants' Brief at 4-5 (footnote omitted). VALIC made similar representations in its literature soliciting participants for its fixed annuity plan. A formal written proposal, which VALIC said was sent to "virtually all, if not all, prospective customers" in the Midwest Region during the years 1979 to 1983, contained the following question and answer:

Describe the basis for the dividends or current interest rate illustrated above. The current rate of interest is composed of the guaranteed interest rate plus "excess interest." Excess interest is declared and guaranteed for deposits received in the Fixed Account on a calendar quarter basis by the Board of Directors of VALIC. Excess interest is computed daily and credited on amounts remaining in a participant's Fixed Account at the end of each calendar quarter.

VALIC employs the new money method for crediting excess interest. The current interest rate is paid on monies for the period in which it is in effect. Should the current interest rate change (i.e., up or down), it would not affect a participant's past contributions but only those contributions deposited while the new rate is in effect. A change in the current rate would in no way affect the past accumulations in a participant's account balance.

Defendants' Memorandum in Opposition to Plaintiff's Motion for Class Certification, Exhibit C (emphasis added). Based on repeated statements such as this made by VALIC coupled with VALIC's failure to assert the right to alter past bands, this court concluded that the interest bands were guaranteed for the life of the contract.

We will accept solely for the purposes of this rehearing VALIC's assertion that it had the right to change at any time the interest bands paid on past deposits. The question then becomes what effect does this new fact have on our determination that the fixed annuity was an insurance product rather than a security and therefore not subject to federal securities laws. Not surprisingly, VALIC argues that the soundness of our prior determination is unaffected. VALIC suggests that we merely delete from our opinion the following sentence: "Under this method, VALIC in effect guaranteed the excess interest rate on every deposit for the life of the annuity contract." At 1134. Otto, on the other hand, argues that the correctness of that sentence is crucial to the opinion's determination that the fixed annuity is not a security but an insurance product. Otto requests, both in its response to VALIC's motion and in its petition for rehearing, that we withdraw our entire discussion of this issue and find instead that the fixed annuity is a security. We agree with Otto that we cannot simply delete the sentence and leave the remainder of the discussion untouched. We therefore supplement section II of our prior opinion with this opinion. Upon reexamination in light of VALIC's newly asserted right to alter past interest bands, we hold that VALIC's fixed annuity plan is a security subject to the federal securities laws.

The amount of discretion retained by VALIC to alter the interest it paid under the fixed annuity is relevant to the level of the investment risk assumed by VALIC. As discussed in our previous opinion, the Supreme Court, this circuit and the Securities and Exchange Commission (the "SEC") all have found that the degree of investment risk assumed by the insurance company is an important factor in determining whether a particular annuity plan is an insurance product or a security. The Supreme Court has stated that insurance "involves some investment risk-taking on the part of the company" and "a guarantee that at least some fraction of the benefits will be payable in fixed amounts." S.E.C. v. Variable Annuity Life Ins. Co., 359 U.S. 65, 71, 3 L. Ed. 2d 640, 79 S. Ct. 618 (1959). The Court has also noted that there is "a basic difference between a contract which to some degree is insured and a contract of insurance." S.E.C. v. United Benefit Life Ins. Co., 387 U.S. 202, 211, 87 S. Ct. 1557, 18 L. Ed. 2d 673 (1967); see also Peoria Union Stock Yards Co. Retirement Plan v. Penn Mutual Life Insurance Co., 698 F.2d 320 (7th Cir. 1983). The SEC recently enacted Rule 151 which defines more precisely what constitutes sufficient investment risk-taking by an insurance company to ensure that an annuity will be considered an insurance product and exempt from the federal securities laws pursuant to section 3(a)(8) of the 1933 Securities Act. VALIC itself relied on the then proposed Rule 151 in its initial brief before this court. VALIC argued that "although the Rule, even if adopted, would not apply to the product sold (between 1975 and 1982) to Otto and other class members, the . . . fixed annuity nonetheless largely satisfies the requirements contained in the proposed Rule. . . ." Defendants' Brief at 17.

The second of the three prongs of Rule 151 requires that "the insurer assumes the investment risk under the contract" as further defined in the rule. In order for the insurer to be "deemed to assume the investment risk" under the rule, the insurer must, among other things, "guarantee[] that the rate of any interest to be credited in excess of [the guaranteed minimum] . . . will not be modified more frequently than once per year." In its brief on rehearing, VALIC concedes that the fixed annuity does not satisfy this requirement given VALIC's claimed right to alter past interest bands. VALIC asserts that it has the absolute right to stop all excess interest payments on all deposits, past or present: "Excess interest is wholly discretionary; with its unfettered discretion, VALIC can calculate excess interest by any method it chooses, it can elect to change the current interest rate paid on deposits, it can change the rates on past contributions, and (although competition makes it unlikely) it can stop paying excess interest altogether -- at any time." Defendants' Brief on Rehearing at 8 (footnote omitted). A claimed right to change established excess interest rates and to eliminate excess interest payments entirely at any time surely tends to shift the investment risk from VALIC to the plan participant. VALIC, however, argues that its failure to meet this requirement of Rule 151 does not require a change in our prior determination that the fixed annuity qualified for the 3(a)(8) exclusion. VALIC argues that our prior conclusion that VALIC bears a sufficiently substantial risk "is solidly based on the substantiality of the guaranteed rates, a fact entirely independent of the availability of discretionary excess interest." Id. at 9 (emphasis in original).

The SEC in adopting Rule 151 rejected VALIC's view that guaranteeing a low minimum interest rate is a sufficient assumption of the investment risk by the insurance company. In Securities Act Release No. 6645 in which the SEC offers guidance in interpreting Rule 151, the SEC notes that several commentators suggested that the requirement of a one-year excess interest guarantee be removed from the rule. The SEC rejected that suggestion and retained the one-year requirement, explaining its reasoning as follows:

While the commentators make some reasonable arguments, the Commission is adopting the one-year requirement as proposed. Taking the position that various types of excess interest contracts are entitled to rely on the section 3(a)(8) exclusion is itself a major step. The length of time between interest rate modifications is one legitimate measure of the degree of investment risk assumed by the insurer. Designing a "safe harbor" rule is essentially a matter of balancing the legitimate interests of flexibility in structuring insurance products against the need to provide adequate investor protection. Where the limits of the "safe harbor" are set is a matter of discretion and judgment. The Commission believe, therefore, that the one-year period is, on balance, a reasonable condition, complementing the two other components of the rule's investment risk test.

Definition of Annuity Contract, Discussion Accompanying Enactment of Rule 151, Securities Act Release No. 6645, Fed. Sec. L. Rep. (CCH) P 84,004, at 88,134 (May 29, 1986). We find that on the facts of this case the minimum interest rates guaranteed under VALIC's fixed annuity plan, although somewhat in excess of those required by Rule 151, do not alone place the investment risk on VALIC sufficiently to exempt the plan from the federal securities laws. To find otherwise we would have to overlook entirely any requirement for a guarantee of excess interest. To do this would be to disregard completely one element contained in the investment risk test of the SEC's safe harbor Rule 151. Admittedly this is not an element relied on previously in court decisions distinguishing securities from insurance products. But it is an element that the SEC has insisted on over the objection of some commentators. Because Rule 151 was cited to us by VALIC as a relevant test, we are unwilling to ignore it to the degree urged by VALIC. We do not say that Rule 151 defines the meaning of "security"; it is a safe harbor rather than a definitional rule, as our first opinion observes, see supra at 1133 n.2. But VALIC's argument directly under the statute depends on its assertion that the guaranty of return here requires calling the instrument insurance under ยง 3(a)(8) even if the prospect of "excess" interest is a principal inducement to purchase this particular instrument. Because the contract actually leaves the investor with an investment risk significant enough to throw its status into doubt, VALIC's argument in this court effectively depended on its own analogy to the standards of Rule 151, which has not sufficed. We therefore find that VALIC's fixed annuity plan is a security. On rehearing, we reverse the district court's order granting summary judgment for the defendants on the alleged violations of the Securities Exchange Act of 1934 and remand for further proceedings consistent with this opinion.





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