Thursday, December 18, 2014

Life Settlement Promoters’ Pre-Sale Efforts Satisfied Howey, NASAA Argues

[This story previously appeared in Securities Regulation Daily.]

By John M. Jascob, J.D.

NASAA has urged the Texas Supreme Court to uphold a lower court’s ruling that life settlements sold by Life Partners, Inc. were securities under the Texas Securities Act. Filing a brief as amicus curiae, NASAA argued that the petitioners’ managerial efforts prior to the sales were significant and essential to the success of the investment, thereby satisfying the fourth prong of the Howey test for the existence of an investment contract, and thus a security, under the Texas Securities Act (Life Partners, Inc. v. Arnold, December 12, 2014).

Investment contracts. NASAA noted that Texas courts have applied the Howey test broadly when determining the existence of an investment contract. While Howey’s fourth prong refers to profits derived from the “sole efforts of others,” the Texas courts have adopted a broader approach, requiring only that the managerial efforts by persons other than the investor be “undeniably significant ones,” which affect the failure or success of the enterprise. As framed by NASAA, the case before the Texas Supreme Court turns on the question of whether the efforts undertaken by the petitioners prior to selling their life settlement contracts to investors can be considered under Howey, or whether only the petitioners’ post-sale efforts can be considered.

Flawed reasoning. NASAA criticized the petitioners’ reliance upon the “flawed” reasoning of the D.C. Circuit in SEC v. Life Partners, Inc. (D.C. Cir. 1996), where the court ignored the pre-sale efforts of the promoter in holding that the life settlements at issue were not investment contracts. NASAA observed that the D.C. Circuit’s decision has been roundly criticized by the federal bench as an anomalous and arbitrary departure from the precedents and principles of securities law. Several state courts have also rejected the Life Partners decision, stating that the decision rests upon flawed logic, lacks precedent, or ignores the purposes of the blue sky laws.

Moreover, the rigid rule set down in Life Partners frustrates the investor protection rationale that underlies securities regulation, NASAA argued. NASAA believes that excluding a promoter’s pre-sale activities from consideration when undertaking the Howey analysis will deny investors meaningful disclosures about their potential investments. In NASAA’s view, the rigid pre-purchase/post-purchase distinction set forth in Life Partners results in an inflexible and artificial approach to analyzing an investment, elevating the form of a transaction over its substance and ignoring the U.S. Supreme Court’s direction that the definition of a “security” is a flexible rather than a static principle.

Passive investors. The issue in the present case, NASAA stated, is whether the investors relied on the efforts of the promoter to make a profit, regardless of when those efforts took place. NASAA noted that the investors in the petitioners’ life settlement contracts were, by design, passive investors that relied on the petitioners to undertake the significant efforts required to make their investments profitable. For example, the investors relied on the petitioners’ expertise in selecting, evaluating, and pricing suitable life insurance policies. The investors further relied on the petitioners’ services in making on-going premium payments and collecting the insurance benefits upon a policyholder’s death. Accordingly, the lower court correctly found that the life settlement contracts sold by petitioners satisfied Howey’s four prongs, making them investment contracts under the Texas Securities Act, NASAA argued.

The case is No. 14-0122.

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