New Federal Appellate Court Ruling Holds That Viatical Settlement Interests Are Investment Contracts, Requiring SEC Regulation (CC 05-18)

Reminder: Background on Viatical Settlements

Viatical settlements, which came into existence only in the 1980s, have become an important means for terminally ill insured`s of lifetime access to their funds.  They have also generated exceptional controversy because of their extraordinary potential for abuse.  This Service has explained the history of viatical settlements, how they work, the structure of the industry, the circumstances under which they are useful and legitimate planning devices, the circumstances under which they are subject to abuse, and many other matters, in numerous places, including  Section 50.8, “Viatical Settlements, Life Settlements, and the Secondary Insurance Market”; and  Section 50.7, “The Insurable Interest Requirement for Life Insurance: Recent Developments”

This Current Comment concerns an issue in the secondary market, from the investor’s side.  In a typical viatical settlement transaction, the viatical settlement provider purchases a life policy from a terminally ill insured (a “viator”) for a lump sum that is a fraction of the death benefit.  The viatical settlement provider continues to pay the premiums and ultimately collects the death benefit.  Its real profit, however, typically comes when it turns around and markets fractional interests in the policy to investors. 

Investing in Death?  SEC v. Life Partners

Some might say that such a fractional interest looks for all the world like a security.  The viatical settlement company solicits money from the investor.  The money represents a fraction of the proceeds of the life policy.  When the viator dies, the investor is paid that fraction—the exact amount depending on the exact date of death, the sooner the better.  How does this differ, except in morbidity, from buying bonds or shares of Microsoft?

That is the position the Securities and Exchange Commission took in SEC v. Life Partners, 87 F.3d 536 (D.C. Cir. 1996).  It argued that fractional interests in viatical settlements in the secondary market were investment contracts under the federal securities laws, subject to registration.  The Court of Appeals for the D.C. Circuit disagreed.  Whether a contract is a security is analyzed under the three-part test of a famous United States Supreme Court case, known to every law student, called SEC v. W.J. Howey Co., 328 U.S. 293 (1946): an investment contract is a security subject to the Act if investors purchase with (1) an expectation of profits arising from (2) a common enterprise that (3) depends upon the efforts of others.  The D.C. Circuit had no problem with the first two prongs of the test but could not agree that investment success “depended on the efforts of others” since all that was necessary once the interests were purchased was for the viators to die, and the sponsors were just sitting around waiting for them to do so.  A blistering dissent criticized this “bright-line” distinction between pre-purchase and post-purchase managerial activities, but to no avail, and it looked as if the SEC had unintentionally foreclosed any possibility of ever regulating viatical settlements at the federal level.

Until now.

SEC v. Mutual Benefits Corp.: Regulation Revived?

In SEC v. Mutual Benefits Corp., No. 04-14850 (11th Cir. May 6, 2005), the SEC seems to have taken Life Partners by the horns.  In the general litigation it is pursuing Mutual Benefits Corp. (MBC), a viatical settlement provider that among other things, it alleges, exaggerates the accuracy of its life expectancy predictions, doesn’t send policies to doctors for life expectancy evaluation until after the investor closes anyway (and backdates the evaluation), and essentially had to engage in a Ponzi scheme to cover its obligations.  In the case just decided, MBC argued that the federal court has no jurisdiction because the fractional interests it is selling are not investment contracts, under the Life Partners doctrine.  And it lost.

The Eleventh Circuit in MBC specifically rejected the Life Partners argument, with little discussion.  It observed that post-purchase activities by the viatical settlement provider might help satisfy the Howey test, but there was nothing in Howey to limit the inquiry to them.  It cited instances in which combinations of pre- and post-purchase activities had contributed to a finding that promoters had offered investment contracts.  On the facts, it concluded that “MBC thus offered what amounts to a classic investment contract. Investors were offered and sold an investment in a common enterprise in which they were promised profits that were dependent on the efforts of the promoters.”  As importantly, the opinion is rife with language about the broad purpose of the securities laws, quoting Howey to the effect that the Supreme Court’s approach in that case “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promises of profits” 328 U.S. at 299, 66 S. Ct. at 1103, and even more significantly quoting a case from last year, Edwards v. United States, 540 U.S. 389, 124 S. Ct. 892 (2004): “‘Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.’ To that end, it enacted a broad definition of ‘security,’ sufficient ‘to encompass virtually any instrument that might be sold as an investment.’” 540 U.S. at 393, 124 S. Ct. at 896 (citation omitted).

Evaluation and Conclusion

This language from Edwards is significant for two reasons.  From the point of view of theory, it is obviously broad enough to encompass fractional interests in viatical settlements.  If the issue reaches the Supreme Court, the side in favor of regulation has the quotes on its side already.  But also, Edwards was a case in which the Supreme Court reversed the Eleventh Circuit on a different Howey issue.  It is clear that the appeals court is crafting this opinion—as courts have been known to do—to make it as hard to reverse as possible.  Given the choice between such an opinion and the shakily reasoned Life Partners, it is really not hard to see where to put the smart money.

MBC could not appeal this ruling at this point anyway; it’s what is called an interlocutory appeal, one taken in the middle of a case over a procedural or jurisdictional issue that could make further proceedings unnecessary.  But once the MBC litigation is concluded there will be a conflict in the circuits and an issue ripe for decision by the Supreme Court.  Legitimate viatical settlement providers should be the first ones cheering for a finding that the secondary market is a market in investment contracts and that SEC regulation is required.  Legitimate providers are tainted in a climate that allows companies such as MBC (according to the undisputed facts recited in the Eleventh Circuit’s opinion) to flourish, and consumers—on both the viator and investor sides—are harmed by their inability to find those legitimate providers.  Life Partners was a badly reasoned and socially harmful decision; the viatical settlement industry can only benefit if it is ultimately disapproved.

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