Federal Law Prevails In Fraudulent Annuity Sales

June 4, 2001 (PLANSPONSOR.com) - Suits alleging fraud in the sale of variable annuities - including those as an investment in 401(k) or IRAs - are preempted by federal law, according to a recent ruling of the 2nd US Circuit Court of Appeals.

In Lander v. Hartford Life & Annuity Insurance Company, the court ruled that variable annuities are “covered securities” under the Securities Litigation Uniform Standards Act of 1998 (SLUSA), and that class actions alleging fraud in their sale fall under the federal jurisdiction of the SLUSA, according to the New York Law Journal.

In its ruling, the court also became the first federal appellate court to address a second, related issue when it ruled that the McCarran-Ferguson Act does not alter the “normal rules of preemption” under SLUSA. The Act gives states a dominant role in the regulation of the insurance industry.

Hybrid Securities

Variable annuities involve a contract in which a purchaser (annuitant), makes payment to a provider (typically an insurance company), and has some control over how the money is invested. The annuitant begins receiving payments once the policy is mature.

However, most of these annuities also provide for a death benefit to be paid to a survivor if the annuitant dies before the policy matures. This provision makes the annuities a “hybrid product” with both the characteristics of insurance products and securities.

Under the Internal Revenue Code (IRC), the annuitant is taxed only once payment begins — but that tax advantage is wasted if the funds used to purchase the policy are already tax deferred through a tax-advantaged investment vehicle such as a 401(k) plan or an Individual Retirement Account.

Too Much Redundancy

Writing for the 2nd Circuit, Judge Chester J. Straub said “[t]he plaintiffs claim that they relied upon the advice and expertise of Hartford Life representatives who misrepresented the suitability of variable annuities and failed to warn consumers of the tax redundancy that occurs when the products are purchased with already tax deferred dollars.”

Those same plaintiffs also alleged that fees charged in the use of variable annuity contracts resulted in a loss of as much as one-third of the value of their accounts, compared with other investment products.

Rule of Law

The case was initially brought under Connecticut statutory and common law, but Hartford Life prevailed in having the case removed to the U.S. District Court for the District of Connecticut. The plaintiffs moved for a remand, but Chief Judge Alfred V. Covello disagreed and dismissed the suit based on SLUSA’s preemption requirement. That requirement holds that no class action based on the statutory or common law of a state can be brought where it involves misrepresentations in the purchase or sale of a covered security.

That dismissal was upheld on appeal. The court held that:

  • the U.S. Supreme Court has already determined that the variable annuity contracts are securities, and that issuers of variable annuities must comply with the Investment Company Act of 1940 (SEC v. Variable Annuity Life Insurance Company of America).
  • Insurance companies may sell variable annuities only through separate investment accounts that must be registered with the Securities and Exchange Commission pursuant to the 1940 Act.

Consequently, since variable annuities are securities, and because the separate accounts used for marketing these products are registered with the SEC under the Investment Company Act, the removal to federal court under SLUSA was justified.

The court also ruled that the McCarran-Ferguson Act, which for the most part leaves insurance regulation to the states, was not trampled in this case.

Acknowledging the hybrid nature of the securities, the court held that “Congress clearly intended to apply SLUSA to variable insurance products in cases where private individuals bring class actions based on state law alleging fraud in the sale of covered securities.”