The Meaning of Life Settlements: Are They Securities Or Not?

People at a Table

“Life settlements” are financial transactions in which the original owner of a life insurance policy sells it to a third party for an up front, lump sum payment.  The amount paid for the policy is less than the death benefit on the policy, yet greater than the amount the policyholder would otherwise receive from an insurance company if the policyholder were to surrender the policy for its cash value.  For the life settlement investor that buys the policy, the anticipated return is the difference between the death benefit and the purchase price plus the amount paid in premiums to keep the policy in force until the death benefit is payable.

Some commentators have deemed life settlements as essentially a “bet” on the life of the insured.  The longer the insured lives, the lower the rate of return on the investment.  Critics of life settlements are quick to point out that investors have a financial interest in the early demise of the insured person.  The life settlement industry has been subject to extensive litigation for several years.

An important and as yet unsettled question is whether life settlements are “securities” as defined under federal and state securities law.  This basic question has important ramifications for how life settlement contracts will be treated by courts and regulators.

The SEC’s position on this important issue has been clear for several years.  An SEC task force released a staff report in 2010 recommending that life settlements be defined as securities. The report noted that 48 states treat life settlements as “securities” under state securities laws, although some states have exceptions for the initial sale of a life insurance policy to a licensed life settlement provider.  Federal courts, however, have split over this issue, creating uncertainty among those in the life settlements industry and the lawyers who represent them.

Recent cases in Texas, which is one of the two states yet to resolve this issue, shows the different schools of thought that have resulted in divergent federal opinions on whether life settlements are securities under the federal securities laws.

Last month, the Dallas Texas Court of Appeals, in Arnold v. Life Partners, Inc., 05-12-00092-CV, 2013 WL 4553379 (Tex. App. Aug. 28, 2013), held that life settlements are securities falling under the Texas Securities Act (“TSA”). In reaching this conclusion, the Court applied the U.S. Supreme Court’s seminal “Howey test” which, as adopted by the Texas Supreme Court, provides that a financial instrument is an “investment contract” under Howey if it meets the following requirements: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profit; (4) solely from the efforts of others.

In Arnold, the debate involved the fourth prong of the Howey test.  Specifically, the court examined whether the profits in question were derived “solely” from the entrepreneurial or managerial efforts of others.  In analyzing this requirement, the Texas appellate court adopted the Eleventh Circuit’s analysis in SEC v. Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005).  The Eleventh Circuit’s approach involved a flexible interpretation of the “efforts of others” requirement and held that efforts of life settlement promoters both prior to and after the investors’ purchases of the policies were relevant.  Under this flexible approach, the Texas appellate court reasoned that the profits at issue “depended almost entirely upon Life Partners’ expertise in choosing the policies, estimating life expectancy, negotiating an advantageous price, and monitoring the policy to keep it in force.”  Accordingly, the Texas appellate court found the fourth prong of the Howey test to be satisfied and life settlements to constitute securities under the TSA.

Other federal courts have followed the more flexible interpretation of the “efforts of others” prong in finding life settlements to be securities under federal law. See e.g. Wuliger v. Eberle, 414 F. Supp. 2d 814, 824 (N.D. Ohio 2006) (the promoter’s selection of the policy is critical to the investor’s expectation of profit and thus satisfied the “efforts of others” prong); In re Trade Partners, Inc. Investors Litig., 1:07-MD-1846, 2008 WL 3992168 (W.D. Mich. Aug. 22, 2008).

The Texas appellate court’s recent decision in Arnold, however, departs from other Texas authority reaching the opposite conclusion. In Griffitts v. Life Partners, Inc., 10-01-00271-CV, 2004 WL 1178418 (Tex. App. May 26, 2004), the Waco Court of Appeals held that life settlements were not securities because they did not satisfy the fourth prong of the Howey test.  In analyzing this requirement, the Waco Court of Appeals followed a 1996 decision by the D.C. Circuit, SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), in which the D.C. Circuit considered only post-purchase activities by third parties under the Howey test.  Under the D.C. Circuit’s stricter approach, the “efforts of others” in the Griffitts case was found to be inconsequential to the profitability of life settlements, given that profits depended solely on the mortality of the insured.

The conflict between these two Texas decisions, rooted in the conflict among the federal appellate courts, may suggest the need for a resolution by the U.S. Supreme Court.  The disagreement among federal courts, however, extends beyond just the fourth prong of the Howey test.  Federal courts have also disagreed over whether life settlements satisfy the “common enterprise” prong of the Howey test, see e.g. Zang v. Alliance Financial Services Of Illinois, Ltd., 08 C 3370, 2010 WL 3842366 (N.D. Ill. Sept. 27, 2010), and whether they may be deemed securities because they constitute “notes” as opposed to “investment contracts.”  See e.g. S.E.C. v. Tyler, CIV.A.3:02 CV 0282 P, 2002 WL 32538418 (N.D. Tex. Feb. 21, 2002).  Clearly, the traditional Howey test is not unlocking the meaning of life settlements under state and federal securities laws.