American Equity Investment Life Insurance Company v. SEC

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 8, 2009 Decided July 21, 2009
Reissued July 12, 2010

No. 09-1021

AMERICAN EQUITY INVESTMENT LIFE INSURANCE COMPANY,
ET AL.,
PETITIONERS

v.

SECURITIES AND EXCHANGE COMMISSION,
RESPONDENT

Consolidated with 09-1056

On Petitions for Review of an Order
of the Securities & Exchange Commission

Eugene Scalia argued the cause for petitioners American
Equity Investment Life Insurance Company, et al. With him on
the briefs were Barry Goldsmith and Daniel J. Davis.

Rodney F. Page argued the cause and filed the briefs for
petitioner National Association of Insurance Commissioners.
Julius A. Rousseau entered an appearance.
 2

Kenneth W. Sukhia was on the brief for amici curiae Phillip
Roy Financial Services, LLC and Phillip R. Wasserman in
support of petitioners.

James F. Jorden, Frank G. Burt and Gary O. Cohen were
on the brief for amicus curiae Allianz Life Insurance Company
of North America in support of petitioners.

Michael A. Conley, Deputy Solicitor, Securities &
Exchange Commission, argued the cause for respondent. With
him on the brief were David M. Becker, General Counsel, Jacob
H. Stillman, Solicitor, and Dominick V. Freda and William K.
Shirey, Senior Counsel.

Deborah M. Zuckerman, Rex Staples, Stephen Hall, and
Michael Lacek were on the brief for amici curiae AARP, et al.
in support of respondent. Michael R. Schuster entered an
appearance.

Before: SENTELLE, Chief Judge, and GINSBURG and
ROGERS, Circuit Judges.

Opinion for the Court filed by Chief Judge SENTELLE.

SENTELLE, Chief Judge: The Securities Act of 1933, 15
U.S.C. §§ 77a et seq. (the Act), exempts from federal regulation
annuity contracts issued by a corporation subject to regulation
by state insurance laws. Petitioners seek review of a rule
promulgated by the Securities and Exchange Commission (SEC
or Commission) stating that fixed indexed annuities (FIAs) are
not annuity contracts within the meaning of the Act. As a result
of this new rule, FIAs are subject to the full panoply of
requirements set forth by the Act, instead of being subject solely
to state insurance laws. Petitioners argue that the Commission
unreasonably interpreted the term “annuity contract” not to
 3

include FIAs. Petitioners also assert that the SEC failed to fulfill
its statutory responsibility under the Act to consider the effect of
the new rule on efficiency, competition, and capital formation.
Because we hold that the SEC’s interpretation of “annuity
contract” is reasonable under Chevron, we deny the petitions
with respect to this issue. We grant the petitions, however, with
respect to petitioners’ alternate ground that the SEC failed to
properly consider the effect of the rule upon efficiency,
competition, and capital formation. Accordingly, we vacate the
rule.

I. BACKGROUND

A.

The Securities Act of 1933 governs the offer or sale of any
security through interstate commerce. The Act defines the term
“security” as including any “investment contract.” 15 U.S.C. §
77b(a)(1); SEC v. Variable Annuity Life Ins. Co. of Am.
(VALIC), 359 U.S. 65, 67-68 (1959). Section 3(a)(8) of the Act,
however, provides an exemption under the Act for an “annuity
contract” or “optional annuity contract” subject to state
insurance laws. 15 U.S.C. § 77c(a)(8).

A traditional fixed annuity is a contract issued by a life
insurance company, under which the purchaser makes a series
of premium payments to the insurer in exchange for a series of
periodic payments from the insurer to the purchaser at agreed
upon later dates. In a fixed annuity, the insurance company
guarantees that the purchaser will earn a minimum rate of
interest over time. Fixed annuities are subject to state insurance
law regulation, and are exempt from federal securities laws. See
id. State insurance laws governing fixed annuity contracts
require insurance companies to guarantee a minimum of the
contract value after any costs and charges are applied. These
 4

state laws generally require the minimum guarantee be at least
87.5 percent of the premiums paid, accumulated at an annual
interest rate of 1 to 3 percent. Indexed Annuities and Certain
Other Insurance Contracts (Final FIA Rule), 74 Fed. Reg. 3138,
3141 (Jan. 16, 2009) (to be codified at 17 C.F.R. Parts 230 and
240). The laws also generally impose disclosure and suitability
requirements, which vary from state to state.

A fixed index annuity (FIA) is a hybrid financial product
that combines some of the benefits of fixed annuities with the
added earning potential of a security. Like traditional fixed
annuities, FIAs are subject to state insurance laws, under which
insurance companies must guarantee the same 87.5 percent of
purchase payments. Unlike traditional fixed annuities, however,
the purchaser’s rate of return is not based upon a guaranteed
interest rate. In FIAs the insurance company credits the
purchaser with a return that is based on the performance of a
securities index, such as the Dow Jones Industrial Average,
Nasdaq 100 Index, or Standard & Poor’s 500 Index. Depending
on the performance of the securities index to which a particular
FIA is tied, the return on an FIA might be much higher or lower
than the guaranteed rate of return offered by a traditional fixed
annuity. Due to the fact that the purchaser’s actual return is
linked to the performance of a securities index, however, the
purchaser’s return cannot be calculated until the end of the
crediting period. Insurance companies typically apply an annual
crediting period; that is, the index-linked interest of an FIA is
typically calculated on an annual basis after each one-year
period ends.

B.

While this is the first case in which we have had occasion
to address the § 3(a)(8) annuity exemption as it regards FIAs,
the Supreme Court has offered guidance on the scope of the
 5

exemption in VALIC, 359 U.S. 65, and SEC v. United Benefit
Life Ins. Co., 387 U.S. 202 (1967). In VALIC, the Supreme
Court considered whether a variable annuity fell within the §
3(a)(8) exemption. A variable annuity is a financial product
under which purchasers pay premiums that are invested in
common stocks and other equities to a greater degree than
traditional annuities, and the benefit payments vary with the
success of the investment management. See VALIC, 359 U.S. at
69. The Court explained that a variable annuity did not fall
within the § 3(a)(8) exemption because it placed “all the
investment risks on the [purchaser], none on the company.” Id.
at 71. As the Court said, “the concept of ‘insurance’ involves
some investment risk-taking on the part of the company.” Id.
“‘[I]nsurance’ involves a guarantee that at least some fraction of
the benefits will be payable in fixed amounts.” Id. Therefore,
an issuer of an annuity “that has no element of a fixed return
assumes no true risk in the insurance sense.” Id. The fact that
there exists a risk of declining returns in difficult economic
times is not sufficient to show that the insurer has assumed more
risk under the contract. See id. Accordingly, because the
variable annuity at issue did not offer a “true underwriting of
risks, the one earmark of insurance,” the Court held that it did
not fall within the exemption offered to traditional fixed
annuities offered by insurers. Id. at 73. In a concurring opinion
later approved by the full Court in United Benefit, Justice
Brennan explained that when “a brand-new form of investment
arrangement emerges which is labeled ‘insurance’ or ‘annuity’
by its promoters, the functional distinction that Congress set up
in 1933 . . . must be examined to test whether the contract falls
within the sort of investment form that Congress was then
willing to leave exclusively to the State Insurance
Commissioners.” Id. at 76 (Brennan, J., concurring); see United
Benefit, 387 U.S. at 210.
 6

In United Benefit, the Court concluded that another product
similar to a variable annuity called a “Flexible Fund Annuity”
was not exempt under § 3(a)(8) of the Act. A Flexible Fund
functioned in much the same way as a variable annuity. Most
notably, the purchaser paid premiums into a separate account
that was primarily invested in common stocks, with the object
of producing capital gains as well as an interest return. United
Benefit, 387 U.S. at 205. Unlike the variable annuity in VALIC,
however, the insurer guaranteed that the purchaser would
receive a percentage of his premiums back. This percentage
gradually increased from 50 percent of net premiums in the first
year to 100 percent after 10 years. Id. United Benefit argued
that, under VALIC, the existence vel non of substantial
investment risk by the insurer ultimately determined whether a
product fell within the § 3(a)(8) exemption.

The Court disagreed that VALIC should be interpreted so
narrowly. Id. at 210. Rather, the critical inquiry under § 3(a)(8)
was whether the product at issue “‘involve[d] considerations of
investment not present in the conventional contract of
insurance.’” Id. (quoting Prudential Ins. Co. v. SEC, 326 F.2d
383, 388 (3d Cir. 1964)). In concluding that the Flexible Fund
did not fall within § 3(a)(8), the Court relied significantly on the
fact that the Flexible Fund “appeal[ed] to the purchaser not on
the usual insurance basis of stability and security but on the
prospect of ‘growth’ through sound investment management.”
United Benefit, 387 U.S. at 211. Though the Court
acknowledged that the “guarantee of cash value based on net
premiums reduces substantially the investment risk of the
contract holder,” it reasoned further that “the assumption of an
investment risk [by the insurer] cannot by itself create an
insurance provision under the federal definition.” Id. (citing
Helvering v. Le Gierse, 312 U.S. 531, 542 (1941)). The Court
recognized that a “basic difference” exists between “a contract
which to some degree is insured and a contract of insurance.”
 7

United Benefit, 387 U.S. at 211. In the case of the Flexible
Fund, the insurer’s assumption of risk was minimal. The insurer
was “obligated to produce no more than the guaranteed
minimum at maturity, and this amount is substantially less than
that guaranteed by the same premiums in a conventional
deferred annuity contract.” Id. at 208.

C.

Since the Court’s decisions in VALIC and United Benefit,
the SEC has engaged in rulemaking to address the newer
financial products that have entered the market. In the mid-
1980s, the SEC promulgated Rule 151 in response to the
creation of a new hybrid financial product called a guaranteed
investment contract. See 17 C.F.R. § 230.151. Guaranteed
investment contracts are like traditional fixed annuities, in that
they promise a return at a guaranteed rate of return for the life of
the contract. In some guaranteed investment contracts, however,
the insurer may agree to periodically pay the purchaser an
additional discretionary amount above the already guaranteed
return amount. Rule 151 provided that, under certain conditions,
a guaranteed investment contract would qualify for the § 3(a)(8)
exemption notwithstanding an insurer’s ability to pay a
discretionary amount to the purchaser. Under Rule 151, a
contract falls within the § 3(a)(8) exemption if:

(1) The annuity or optional annuity contract is issued by
a corporation (the insurer) subject to the supervision of
the insurance commissioner, bank commissioner, or any
agency or officer performing like functions, of any State
or Territory of the United States or the District of
Columbia;

(2) The insurer assumes the investment risk under the
contract as prescribed in paragraph (b) of this section;
 8

and

(3) The contract is not marketed primarily as an
investment.

17 C.F.R. § 230.151(a). Though the SEC considered excluding
from the Rule 151 safe harbor any product in which an issuer
calculates the rate of any excess return by reference to an index,
it concluded that an issuer may reference an index to set the
excess return rate, but only if the rate is set before each crediting
period begins and remains in effect for at least one year.
Definition of Annuity Contract or Optional Annuity Contract,
S.E.C. Release No. 6645, 1986 WL 703849, at *11 (May 29,
1986).

In the mid-1990s, insurance companies began marketing
FIAs. The SEC did not take any regulatory action with respect
to FIAs until 2007. By this time, the sales volume of FIAs had
increased to $24.8 billion; indexed annuity assets totaled $123
billion. A total of 322 FIAs were being offered by 58 insurance
companies. Having grown increasingly concerned that these
FIAs were not being sold through registered broker-dealers and
were not registered with the SEC despite their tie-in to a
securities market, the SEC proposed Rule 151A. Rule 151A
provides that a contract that is regulated as an annuity under
state insurance law is not an “annuity contract” under § 3(a)(8)
of the Act if:

(1) The contract specifies that amounts payable by the
issuer under the contract are calculated at or after the end
of one or more specified crediting periods, in whole or
in part, by reference to the performance during the
crediting period or periods of a security, including a
group or index of securities; and
 9

(2) Amounts payable by the issuer under the contract are
more likely than not to exceed the amounts guaranteed
under the contract.

17 C.F.R. § 230.151A(a). By redefining an “annuity contract”
to exclude FIAs, the Commission sought to ensure that
purchasers of FIAs would be entitled to the full protection of the
federal securities laws, including disclosure, antifraud, and sales
practice protections.

To support this new rule, the SEC first noted that the
Securities Act did not define “annuity contract,” and that FIAs
were not in existence at the time the “annuity contract”
exemption in the Securities Act was enacted. Final FIA Rule,
74 Fed. Reg. at 3142-43. Without express statutory guidance,
the Commission looked to the reasoning set forth in the Supreme
Court’s decisions in VALIC and United Benefit to assess whether
FIAs were the type of financial product that Congress would
have been willing to leave to state insurance regulation. Id. at
3143.

The SEC began its analysis by considering the level of risk
associated with FIAs. Citing VALIC, the Commission reasoned
that “Congress intended to include in the insurance exemption
only those policies and contracts that include a ‘true
underwriting of risks’ and ‘investment risk-taking’ by the
insurer.” Id. (citing VALIC, 359 U.S. at 71-73). The annuities
that were offered at the time of the enactment of the § 3(a)(8)
exemption were fixed annuities that generally involved no
investment risk to the purchaser. Final FIA Rule, 74 Fed. Reg.
at 3143. Therefore, the SEC reasoned, Congress was willing to
offer a securities law exemption to these types of no risk
products because, by their nature, they did not raise the kinds of
problems or risks that the federal securities laws were intended
to address. Id. Additionally, the state insurance laws in
 10

existence could adequately deal with any issues that might arise
from such low risk insurance products. Id. On the other hand,
the SEC explained, “[i]ndividuals who purchase [FIAs] are
exposed to a significant investment risk–i.e., the volatility of the
underlying securities index.” Id. at 3138. At the time an FIA is
purchased, the purchaser “assumes the risk of an uncertain and
fluctuating financial instrument, in exchange for participation in
future securities-linked returns.” Id. at 3143. Unlike the
guaranteed, fixed return offered by a traditional fixed annuity,
the SEC asserted that an FIA’s return was neither known nor
guaranteed. Id. The SEC acknowledged that “indexed annuities
contracts provide some protection against the risk of loss,” but
determined that these provisions did not adequately transfer the
investment risk from the purchaser to the insurer. Id. Because
the value of the purchaser’s investment was entirely dependent
upon an unknown and fluctuating securities index, the
assumption of a guaranteed minimum percentage of the FIA,
though giving FIAs an outward aspect of insurance, was a
superficial and unsubstantial offset of the purchaser’s risk. Id.
Therefore, the SEC reasoned that an FIA’s value is much like
that of a security, as the value of each product depends on the
performance of the market. This securities-like investment risk,
the SEC explained, was the exact type of investment risk that the
Securities Act was created to address. Id.

Though the SEC set forth in Rule 151 that the manner in
which a product was marketed factored into the SEC’s
determination of whether it constituted an annuity contract under
§ 3(a)(8), see 17 C.F.R. § 230.151(a)(3), the SEC opted not to
include such an element in Rule 151A. The SEC noted that the
performance of an FIA is obviously associated with the
performance of a securities index, given the nature of the
product. Final FIA Rule, 74 Fed. Reg. at 3146. Moreover, the
SEC noted that the Supreme Court in VALIC did not consider
how the variable annuity was marketed in determining whether
 11

it fell within § 3(a)(8)’s exemption. Id. For these reasons, the
SEC felt that inclusion of a marketing element in Rule 151A
was unnecessary. Id.

The SEC supplemented its analysis of Rule 151A by
undertaking a consideration of the rule’s promotion of
efficiency, competition, and capital formation, as is required by
§ 2(b) of the Act for certain SEC rulemakings. See 15 U.S.C.
§ 77b(b). The SEC first concluded that Rule 151A would
promote efficiency, reasoning that the rule would extend the
benefits of the disclosure and sales practice protections of the
federal securities laws to FIAs that offered payments to the
purchaser that fluctuated with the securities markets. Id. at
3169. The imposition of disclosure requirements would enable
investors to make more informed investment decisions about
purchasing FIAs, and would promote more suitable
recommendations by issuers of FIAs to purchasers. Id. at 3169-
70. Next, the SEC asserted that the improvement in investors’
ability to make informed investment decisions would increase
competition between issuers of FIAs. The SEC reasoned that
the imposition of federal securities laws to regulate FIAs was
particularly important because it would “bring about clarity in
what has been an uncertain area of law,” id. at 3171, which
would in turn increase competition because registered broker-
dealers “who currently may be unwilling to sell unregistered
[FIAs] because of their uncertain regulatory status may become
willing to sell [FIAs] that are registered.” Id. at 3170. Finally,
the SEC concluded that, based upon the increased efficiency
resulting from the enhanced investor protections under federal
law, Rule 151A would promote capital formation “by improving
the flow of information among insurers that issue [FIAs], the
distributors of those annuities, and investors.” Id. at 3171.

Petitioners seek review of Rule 151A.
 12

II. ANALYSIS

A.

Petitioners first argue that the SEC erred in excluding FIAs
from the definition of “annuity contract” under § 3(a)(8) of the
Act. Petitioners assert that their argument is supported by the
plain language of the provision, as well as by the Supreme
Court’s decisions in VALIC and United Benefit. Petitioners
argue that Rule 151A is in conflict with the text of § 3(a)(8), the
aforementioned decisions of the Court, and the text of the SEC’s
prior rule, Rule 151. Finally, petitioners argue that the SEC
failed to undertake properly its statutory responsibility to
consider Rule 151A’s effect on efficiency, competition, and
capital formation, pursuant to § 2(b) of the Act. We will address
each argument in turn.

When an agency is given express authority to execute and
enforce its enabling statute and to prescribe such rules and
regulations as are or may be necessary to carry out provisions of
the statute, courts must apply a two-step analysis in reviewing
the agency’s interpretation of the statute under Chevron U.S.A.
Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984).
Section 19(a) of the Act bestows upon the SEC the power to
define terms and make rules to that effect. 15 U.S.C. § 77s(a).
Rule 151A, which interprets the term “annuity contract” in
§ 3(a)(8) of the Act is clearly such a rule.

Under Chevron, we first determine whether the statute
being interpreted is ambiguous. If “Congress has directly
spoken to the precise question at issue . . . [then] that is the end
of the matter; for the court, as well as the agency, must give
effect to the unambiguously expressed intent of Congress.”
Chevron, 467 U.S. at 842-43. On the other hand, if the court
determines that the statute is either “silent or ambiguous with
 13

respect to the specific issue,” then Chevron Step One is satisfied.
Id. at 843. Here, Chevron Step One is satisfied because the Act
is ambiguous, or at the very least silent, on whether the term
“annuity contract” encompasses all forms of contracts that may
be described as annuities. Indeed, the analyses in the Supreme
Court’s decisions in VALIC and United Benefit confirm this
ambiguity. See generally VALIC, 359 U.S. 65; United Benefit,
387 U.S. 202. Had the statute been unambiguous, the Court
need not have undertaken such an exhaustive inquiry in
determining whether the two products at issue in those cases
were annuities under § 3(a)(8) of the Act.

Petitioners nevertheless argue that the Court’s decisions in
VALIC and United Benefit establish that an “annuity” falls
outside of § 3(a)(8) only if it is subject to the insurer’s
investment management, and not subject to state insurance laws.
Given the absence of these two elements, petitioners assert,
§ 3(a)(8) clearly governs FIAs because FIAs are not subject to
the insurer’s investment management and are governed by a
panoply of state insurance laws. Petitioners’ argument misses
the mark because it interprets VALIC and United Benefit too
restrictively.

Nothing in those cases indicated that the Court’s
determination whether the § 3(a)(8) exemption applies to
particular contracts depends on the investment management of
the issuer and the applicability of state insurance regulation.
Rather, the Court embraced a broader approach in its § 3(a)(8)
analysis. The Court clearly indicated in both VALIC and United
Benefit that the § 3(a)(8) exemption applied to products that
“‘did not present very squarely the sort of problems that the
Securities Act . . . [was] devised to deal with, and which were,
in many details, subject to a form of state regulation of a sort
which made the federal regulation even less relevant.’” United
Benefit, 387 U.S. at 210 (quoting VALIC, 359 U.S. at 75
 14

(Brennan, J., concurring)). The Court therefore focused its
§ 3(a)(8) analysis on whether the product at issue “involve[d]
considerations of investment not present in the conventional
contract of insurance.” Id. (quotation omitted). Though an
insurer’s investment management actions associated with a
product may be relevant to determining whether that product is
an annuity, this is not the only relevant characteristic.
Petitioners’ reliance on the existence of state law regulation
governing FIAs is also too limited. The Court recognized in
United Benefit that it had “conclusively rejected” in VALIC the
argument that the existence of adequate state regulation was the
basis for the § 3(a)(8) exemption. Id. (quotation omitted).
Therefore, the fact that FIAs are subject to state insurance
regulation does not, without more, place them within the
§ 3(a)(8) exemption. Accordingly, the language of § 3(a)(8)
does not unambiguously include FIAs within the § 3(a)(8)
exemption. In light of the fact that the statute is ambiguous with
respect to the term “annuity contract,” we reiterate that Chevron
Step One is satisfied.

We must next determine whether the SEC’s rule is a
reasonable interpretation of the statute. The SEC’s rule will
satisfy Step Two of the Chevron analysis so long as it meets this
requirement. It is irrelevant that this court might have reached
a different—or better—conclusion than the SEC. See Nat’l
Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S.
967, 980 (2005).

In this case, the SEC has adopted an interpretation that is
based in reason. By their nature, FIAs “appeal to the purchaser
not on the usual insurance basis of stability and security but on
the prospect of ‘growth’ through sound investment
management.” United Benefit, 387 U.S. at 211. An FIA is akin
to an annuity contract with respect to its pay-in and guaranteed
minimum value of purchase payment features. The interest
 15

return rate of an FIA, however, is decidedly more like a security
in that the index-based return of an FIA is not known until the
end of a crediting cycle, as the rate is based on the actual
performance of a specified securities index during that period.
Similar to an investor in securities, a purchaser of an FIA knows
the level of annual return he will receive once the year is
concluded and the index’s value is compared with its value at
the beginning of the year. In FIAs, as in securities, there is a
variability in the potential return that results in a risk to the
purchaser. By contrast, an annuity contract falling under Rule
151’s exemption avoids this variability by guaranteeing the
interest rate ahead of time. As these characteristics show, FIAs
“involve considerations of investment not present in the
conventional contract of insurance.” Id. at 210 (quotation
omitted). Accordingly, the SEC’s interpretation that an FIA
does not constitute an “annuity contract” under § 3(a)(8) of the
Act was reasonable.

Petitioners assert that the SEC based its analysis of Rule
151A on an “insupportable definition of investment risk.” The
SEC determined that a purchaser bears sufficient risk to treat a
product as a security when “[a]mounts payable by the issuer
under the contract are more likely than not to exceed the
amounts guaranteed under the contract.” 17 C.F.R. §
230.151A(a)(2) (emphasis added). In petitioners’ view,
investment risk exists only where the purchaser of a security
faces the possibility of a loss of principal. Petitioners’ view is
certainly a defensible one. However, that is not sufficient to
establish that the SEC’s rule is arbitrary or capricious. As the
SEC points out, comparing two slightly different annuity
products—one with a 5 percent interest rate guaranteed ahead of
time; one with an interest rate that could be between 1 and 10
percent determined at the end of the year—the second product
is riskier than the first product because its potential return could
be lower than the rate of return from the first product, even
 16

though it guarantees a minimum return rate of at least 1 percent.
Moreover, the SEC has also been consistent in its position on
investment risk. When it adopted Rule 151, which provided a
safe harbor to certain types of annuity contracts including those
that based interest payments on an investment index, the SEC
noted that it was allowing products involving investment indices
with the caveat that such index-based interest rates be calculated
in advance of the upcoming year. See Definition of Annuity
Contract or Optional Annuity Contract, S.E.C. Release No.
6645, 1986 WL 703849, at *11. This, the SEC said, would
minimize the investment risk exposure of the purchaser. We
cannot hold that this interpretation is unreasonable.

Petitioners’ argument that the SEC failed to balance the
investment risks assumed by the insurer against those assumed
by the purchaser misses the mark. To the contrary, the SEC
considered the risk to insurers, and weighed that risk against the
risk to the FIA customer in determining whether the product is
an annuity or security. See Final FIA Rule, 74 Fed. Reg. at
3143-50. The SEC concluded in its adopting release that
annuities were those products that included a “true underwriting
of risks” and “investment risk-taking” by the insurer, with more
minimal risk exposure to the purchaser. Id. at 3143. In
traditional fixed annuities, “the insurer bears the investment risk
under the contract.” Id. at 3138. FIAs did not fall within this
term because insurers offering FIAs left a more than minimal
risk upon the purchaser. Rule 151A appears to be the SEC’s
means of ensuring greater protection for consumers exposed to
greater risk when insurers are exposed to less risk than normal.
Indeed, the rule “sets forth a test” to distinguish between those
contracts where the insurer bears more risk by paying a fixed
amount, and those in which the purchaser bears more risk
because he will receive a variable amount that is dependent upon
fluctuating stock market prices. Final FIA Rule, 74 Fed. Reg. at
3145. Such an approach, in light of this risk assessment, is
 17

reasonable. Petitioners’ argument that the SEC’s adoption of
Rule 151A was in error because it allegedly failed to consider
and balance the investment risks of the insurer and purchaser
fails.

Petitioners’ further argument that the SEC failed to account
for marketing in considering whether a product is a security,
though raising a closer issue, does not demonstrate that the
SEC’s adoption of Rule 151A is unreasonable. Admittedly, the
Supreme Court in United Benefit recognized that marketing is
another significant factor in determining whether a state-
regulated insurance contract is entitled to be exempt under
§ 3(a)(8). See United Benefit, 387 U.S. at 211 (contract found
to “appeal to the purchaser not on the usual insurance basis of
stability and security but on the prospect of ‘growth’ through
sound investment management”). The SEC echoed this point
when it enacted Rule 151 by stating that a product issued by a
state-regulated insurance company falls within the § 3(a)(8)
exemption if (1) the insurer assumes the investment risk of the
contract and (2) “[t]he contract is not marketed primarily as an
investment.” 17 C.F.R. § 230.151(a)(3) (emphasis added).
Nevertheless, the SEC’s conclusion that an analysis of
marketing was unnecessary for FIAs because “[i]t would be
inconsistent with the character of such an indexed annuity, and
potentially misleading, to market the annuity without placing
significant emphasis on the securities-linked return and the
related risks” is not unreasonable. Final FIA Rule, 74 Fed. Reg.
at 3146.

At the outset, the Supreme Court never held in either VALIC
or United Benefit that marketing was an essential characteristic
in assessing whether a product falls within the § 3(a)(8)
exemption. Rather, as discussed above, the Court focused its
inquiry on whether the product exhibited “considerations of
investment not present in the conventional contract of
 18

insurance.” United Benefit, 387 U.S. at 210 (quotation omitted);
see also VALIC, 359 U.S. at 75 (Brennan, J., concurring)
(§ 3(a)(8) exemption was to be considered a congressional
declaration “that there then was a form of ‘investment’ known
as insurance (including ‘annuity contracts’) which did not
present very squarely the sort of problems that the Securities Act
. . . [was] devised to deal with”). The fact that the Court
considered how Flexible Funds were marketed only shows that
that inquiry was relevant to Flexible Funds. It does not establish
that the SEC must undertake a complete marketing analysis of
FIAs in order to make a proper § 3(a)(8) determination.
Regardless of that fact, the SEC did consider marketing of FIAs,
and ultimately deemed the inclusion of this factor to be
unnecessary. Again, we cannot say that the SEC’s decision was
unreasonable. Indeed, the key characteristic of FIAs is that they
offer a wide range of potential yearly return interest rates based
on the performance of a securities index. This potential for a
greater rate of return is what makes FIAs potentially more
enticing than those exempt annuities that guarantee an interest
rate ahead of time but at a lower rate. As we have noted above,
this key distinction between these two products shows that FIAs
are more like securities from a risk perspective than other
annuity contracts. Where, as here, the essential characteristic of
the product bestows upon that product obvious securities-like
qualities, it is reasonable to assume that any marketing of the
product would correspondingly be securities-related. It was also
therefore reasonable for the SEC to find that the structure of
FIAs–in particular the potential of securities-linked returns–is
itself an implicit marketing tool aimed at consumers who wish
to participate to some extent in the securities market, and that
the rule need not contain an additional explicit prong addressed
to marketing. Final FIA Rule, 74 Fed. Reg. at 3146. Indeed,
this is in line with much of the analysis in United Benefit. See
United Benefit, 387 U.S. at 211 (“‘The test . . . is what character
the instrument is given in commerce by the terms of the offer,
 19

the plan of distribution, and the economic inducements held out
to the prospect.’”) (quoting SEC v. C.M. Joiner Leasing Corp.,
320 U.S. 344, 352-53 (1943)). The SEC’s reasoning therefore
was not in error.

Contrary to petitioners’ arguments, Rule 151A does not
conflict with Rule 151. Petitioners assert that Rule 151’s
adopting release states that annuity contracts that have interest
rates tied to a securities index can fall within the Rule 151 safe
harbor so long as the rate of interest to be credited is not
modified more frequently than once a year. They argue that
FIAs fall within Rule 151’s safe harbor because the interest rate
tied to the securities index is only determined once a year. This
argument fails, however, because it ignores an express statement
in the same portion of the adopting release of Rule 151 which
states that annuity contracts that have interest rates tied to a
securities index can fall within the Rule 151 safe harbor if the
rate tied to the securities index is calculated prospectively. See
Definition of Annuity Contract or Optional Annuity Contract,
S.E.C. Release No. 6645, 1986 WL 703849, at *11 (“Once
determined, the rate of excess interest credited to a particular
purchase payment or to the value accumulated under the
contract must remain in effect for at least the one-year time
period established by the rule.” (emphasis added)). FIAs,
however, do not calculate their rates of return tied to securities
indices prospectively; their rates are calculated retroactively
once the year is complete. Rule 151A is premised on this very
distinction, and is therefore not in contradiction with Rule 151.

For these reasons, we hold that the SEC’s interpretation of
“annuity contract” was reasonable and Chevron Step Two is
satisfied.
 20

B.

Even though the SEC’s interpretation of “annuity contract”
was reasonable, petitioners argue that the SEC contravened
§ 2(b) of the Act because it failed to consider the efficiency,
competition, and capital formation effects of the new Rule
151A. Section 2(b) of the Act states that, for every rulemaking
in which the SEC “is required to consider or determine whether
an action is necessary or appropriate in the public interest, the
Commission shall also consider, in addition to the protection of
investors, whether the action will promote efficiency,
competition, and capital formation.” 15 U.S.C. § 77b(b).
Petitioners argue that the costs of implementing Rule 151A are
too burdensome and that the imposition of additional regulations
would be inefficient. They also contend that the SEC failed to
properly assess the existence of abuses of FIAs before applying
securities regulations on the issuers of those products. The SEC
counters that it properly rejected petitioners’ concerns regarding
duplicative regulation because the Supreme Court’s decisions in
VALIC and United Benefit made clear that state regulatory
approaches to new products are not conclusive in a § 3(a)(8)
analysis. In any event, the SEC argues that the challenges to its
efficiency, competition, and capital formation analysis under §
2(b) fail because the SEC was not required to undertake such an
analysis when it promulgated Rule 151A.

At the outset, we must reject the SEC’s argument that no
error occurred because the SEC was not required by the
Securities Act to conduct a § 2(b) analysis. “The grounds upon
which an administrative order must be judged are those upon
which the record discloses that its action was based.” SEC v.
Chenery Corp., 318 U.S. 80, 87 (1943). The SEC conducted a
§ 2(b) analysis when it issued the rule with no assertion that it
was not required to do so. Therefore, the SEC must defend its
analysis before the court upon the basis it employed in adopting
 21

that analysis. See id.

We now turn to the merits of the SEC’s § 2(b) analysis. We
review the analysis under the statutory standard set by the
Administrative Procedure Act. 5 U.S.C. § 706. The APA
requires the court to set aside agency action that is “arbitrary,
capricious, an abuse of discretion, or otherwise not in
accordance with law.” Id. at § 706(2)(A). We hold that the
Commission’s consideration of the effect of Rule 151A on
efficiency, competition, and capital formation was arbitrary and
capricious. The SEC purports to have analyzed the effect of the
rule on competition, but does not disclose a reasoned basis for
its conclusion that Rule 151A would increase competition. The
SEC concluded that enacting the rule would resolve the present
uncertainty prevailing over the legal status of FIAs. The SEC
reasoned that the rule “will bring about clarity in what has been
an uncertain area of law.” Final FIA Rule, 74 Fed. Reg. at 3171.
The SEC explained that this newfound “clarity” brought about
by the rule would

enhance competition because insurers who may have
been reluctant to issue indexed annuities, while their
status was uncertain, may decide to enter the market.
Similarly, registered broker-dealers who currently may
be unwilling to sell unregistered indexed annuities
because of their uncertain regulatory status may become
willing to sell indexed annuities that are registered,
thereby increasing competition among distributors of
indexed annuities.

Id. at 3170.

This reasoning is flawed. The lack of clarity resulting from
the “uncertain legal status” of the financial product is only
another way of saying that there was not a regulation in place
 22

prior to the adoption of Rule 151A determining the status of
those products under the annuity exemption of § 3(a)(8). The
SEC cannot justify the adoption of a particular rule based solely
on the assertion that the existence of a rule provides greater
clarity to an area that remained unclear in the absence of any
rule. Whatever rule the SEC chose to adopt could equally be
said to make the previously unregulated market clearer than it
would be without that adoption. Moreover, the fact that federal
regulation of FIAs would bring “clarity” to this area of the law
is not helpful in assessing the effect Rule 151A has on
competition. Again, creating a rule that resolves the “uncertain
legal status” of FIAs might be said to improve competition. But
that conclusion could be asserted regardless of whether the rule
deems FIAs to fall within the SEC’s regulatory reach or outside
of it. Indeed, the SEC would achieve a similar clarity if it
declined outright to regulate FIAs. Section 2(b) does not ask for
an analysis of whether any rule would have an effect on
competition. Rather, it asks for an analysis of whether the
specific rule will promote efficiency, competition, and capital
formation. 15 U.S.C. § 77b(b). The SEC’s reasoning with
respect to competition supports at most the conclusion that any
SEC action in this area could promote competition, but does not
establish Rule 151A’s effect on competition. Section 2(b)
requires more than this. See id.

The SEC’s competition analysis also fails because the SEC
did not make any finding on the existing level of competition in
the marketplace under the state law regime. The SEC asserted
competition would increase based upon its expectation that Rule
151A would require fuller public disclosure of the terms of FIAs
and thereby increase price transparency. The SEC could not
accurately assess any potential increase or decrease in
competition, however, because it did not assess the baseline
level of price transparency and information disclosure under
state law. The SEC nevertheless argues that it is not required to
 23

conduct such a detailed § 2(b) analysis because doing so would
contravene the Supreme Court’s reasoning in United Benefit and
VALIC. According to the Commission, these two cases
established that adequate state regulation is not relevant to
whether a product qualifies for a § 3(a)(8) exemption. See
United Benefit, 387 U.S. at 210 (“The argument that the
existence of adequate state regulation was the basis for the
exemption [under § 3(a)(8)] was conclusively rejected in
VALIC.” (quotation omitted)); VALIC, 359 U.S. at 75 (Brennan,
J., concurring) (“[H]owever adequately State Securities
Commissioners might regulate an investment, it was not for that
reason to be freed from federal regulation. Concurrent
regulation, then, was contemplated by the Acts as a quite
generally prevailing matter.”). Therefore, the SEC argues, it
was reasonable to conclude that state regulation, “no matter how
strong,” could not “substitute for the federal securities law
protections that apply to instruments that are regulated as
securities.” Final FIA Rule, 74 Fed. Reg. at 3170. The SEC’s
reliance on VALIC and United Benefit is misplaced. The SEC’s
obligations under § 2(b) are distinct from the questions posed in
VALIC and United Benefit. Those cases addressed whether a
particular product fell within the § 3(a)(8) exemption; § 2(b)
imposes on the SEC an obligation to consider the economic
implications of certain rules it proposes. See Chamber of
Commerce v. SEC, 412 F.3d 133, 143 (D.C. Cir. 2005).
Accordingly, the SEC’s § 2(b) analysis is arbitrary and
capricious because it failed to consider the extent of the existing
competition in its analysis.

The Commission’s efficiency analysis is similarly arbitrary
and capricious. The SEC concluded that Rule 151A would
promote efficiency because the required disclosures under the
rule would enable investors to make more informed investment
decisions about purchasing indexed annuities. The SEC
advanced further that the rule’s sales practice protections would
 24

enable sellers to promote more suitable recommendations to
investors; this, in turn, would lead to investors making even
better informed decisions, which would offer greater efficiency.
As with its analysis of competition, however, the SEC’s analysis
is incomplete because it fails to determine whether, under the
existing regime, sufficient protections existed to enable
investors to make informed investment decisions and sellers to
make suitable recommendations to investors. The SEC’s failure
to analyze the efficiency of the existing state law regime renders
arbitrary and capricious the SEC’s judgment that applying
federal securities law would increase efficiency.

Finally, the SEC’s flawed efficiency analysis also renders
its capital formation analysis arbitrary and capricious. The
SEC’s conclusion that Rule 151A would promote capital
formation was based significantly on the flawed presumption
that the enhanced investor protections under Rule 151A would
increase market efficiency. This analysis fails with the failure
of its underlying premise.

Having determined that the SEC’s § 2(b) analysis is
lacking, we grant the petitions insofar as they assert that the SEC
failed properly to consider the effect of the rule upon efficiency,
competition, and capital formation. We therefore order that
Rule 151A be vacated.

So ordered.