Agencies are examining the securities status of EIAs

This past spring, high-level officials at the National Association of Securities Dealers started making public statements, warning member firms that they may face significant risk concerning sales of equity index annuities, and advising that: If you can’t be sure whether an EIA is a security or not, you should consider assuming the worst and treating it like a security.

On Aug. 8, 2005, the NASD issued a Notice to Members setting out additional guidance for implementing this advice. Now, more quietly, the Securities and Exchange Commission also has started reexamining the securities status of equity index annuities.

To step back, EIAs are hybrid products that offer both traditional insurance features (minimum guaranteed returns) and the opportunity to participate, to some extent, in the upside potential of the equity markets. They first came to market in 1995 and have been sold, for the most part, as insurance, without SEC registration or NASD sales practice supervision.

The dividing line between “insurance” and “securities” depends on (1) whether the insurance company assumes investment risk, and (2) whether the product is marketed primarily as an investment. EIAs do not seem to fit categorically on either side.

In 1997, the SEC issued a “concept release” concerning “substantial uncertainty” about whether all equity indexed products should be properly characterized as insurance, and asking for industry comment on the structure and marketing of these products. More clarity on this subject may benefit everyone, the release said. For products that qualify as securities, investors would get the protections of the federal securities laws. For real insurance, greater clarity would reduce litigation risk for all parties.

Comments were sent in, but more guidance from the SEC was not forthcoming.

Left to apply existing legal principles on their own, manufacturers and sellers appeared to become comfortable that guaranteeing a minimum return of 90% of principal earning interest at 3% until maturity (the amount required by most state nonforfeiture laws for single premium products) would satisfy the insurance test and justify offering the products without SEC registration.

Now, in mid-2005, clarity on this score is more important than ever. EIA sales are exploding under today’s market conditions and demographics; they appeal strongly to investors nearing retirement who suffered losses in the early 2000s but still feel the allure of the stock market.

At the same time, some companies have found the 90% at 3% guarantee untenable in the persistent low interest environment, and nonforfeiture laws now permit lower, and even variable, rates. Thus, there are products now on the market that are no longer in the old comfort zone.

Finally, annuity sales practices targeted at older investors are in the crosshairs of the plaintiffs’ bar and state regulators. The reality is that agent compensation for selling EIAs can be substantially higher than for other products, which can create a powerful, undisclosed incentive for agents to recommend EIAs to their customers. Without an established regulatory framework, “bad facts” in these cases could make some very bad law for EIAs.

Why should the NASD care? Some NASD-licensed registered representatives are selling EIAs as an “outside business activity,” under NASD Rule 3030, which requires notice to member firms but not their approval or supervision. Because Rule 3030 only works for products that aren’t securities, if the EIAs being sold are, in fact, securities, both rep and firm are violating NASD rules. In any case, the rep is selling a complex instrument with limited liquidity, possibly to elderly investors, without the disclosure and suitability protections that the NASD’s rules provide.

If a rep recommends that a customer liquidate mutual funds, variable annuities or other securities to purchase an EIA, the NASD views that as an integrated transaction–requiring the member firm’s supervision for suitability and full disclosure, whether the EIA itself is a security or not.

For these reasons, the NASD’s Notice to Members requires members to adopt special notice procedures under Rule 3030 and urges them to consider supervising EIA sales as if they were securities.

But should this question really be left to the NASD? The answer to whether any particular EIA is a security will depend on its features and will have implications for all industry participants, not just the NASD’s members and registered representatives.

The SEC is the agency best suited to undertake this analysis and has the benefit of years of study and the comments from the 1997 concept release. It looks like the SEC may agree. Late last month, the SEC’s Division of Investment Management sent a letter to some EIA manufacturers asking for information on certain EIA products.

In 1997, the SEC recognized that more certainty could benefit both buyers and sellers of EIAs. The outlook is improving for seeing this happen in 2005.

Ruth S. Epstein is a partner in the financial services group of Dechert LLP law firm in the Washington, D.C., office. Her e-mail address is ruth.epstein@dechert.com.

The dividing line between “insurance” and “securities” depends on whether 1) the insurer assumes investment risk, and 2) the product is marketed primarily as an investment