Life settlement suit raises questions about duties of reps, firms

A recent lawsuit concerning a failed investment in a life settlement has exposed a new area of regulatory uncertainty and potential liability for registered representatives and their firms.

The suit, which was filed in an Illinois federal court in July, raises the question of the duties of a rep and a firm when a financial adviser recommends that a retail client become an investor in another person’s life insurance policy.

Although regulators have given input on the sale of insurance policies, few have given much thought to the idea of retail clients becoming investors in a life settlement transaction.

Whether such transactions are subject to securities laws depends on the circumstances of the investment transaction itself.

For instance, a life policy that is divided into tranches for multiple investors would be a security under federal law, but the sale of a single policy or a pool of policies to an investor is subject to a facts and circumstances analysis to determine whether it is a securities transaction, said James W. Maxson, who is of counsel in the insurance and reinsurance practice at Morris Manning and Martin LLP.

Although the Financial Industry Regulatory Authority Inc. touched on the topic of investment products that are based on life settlements in a July notice to members, the regulator’s primary focus has been on the interaction between a rep and a client who wishes to sell his or her insurance policy.

FRAUD ALLEGATIONS

In the suit filed in the U.S. District Court for the Northern District of Illinois, Bloomingdale, Ill., physician Charles Giger accused rep James Ahmann and independent broker-dealer J.W. Cole Financial Inc. of fraud, misrepresentation and violation of state and federal securities laws.

The doctor alleges that in 2006 and 2007, Mr. Ahmann — then one of his patients — solicited him to invest a total of about $2 million in “guaranteed bonded life settlements,” with a guaranteed return of up to 15%.

A bonded life settlement has been insured against the risk that a policyholder lives too long.

Dr. Giger asked for his money back after discovering that one of the policies was contestable and that Mr. Ahmann had misled him about the investments, according to the complaint. The physician also alleged that the rep told him that his money would be used to pay all premiums on one of the policies.

In fact, just one payment was made toward that insurance policy, which will default by December if premiums continue to go unpaid.

During the relevant period, Mr. Ahmann was affiliated with J.W. Cole and Pavek Investments. The doctor also filed a Finra arbitration claim against Mr. Ahmann and Pavek in January to get some of his money back.

Pavek Investments and Dr. Giger’s attorney, David T.B. Audley at Chapman and Cutler LLP, did not return calls seeking comment.

J.W. Cole chief compliance officer Melissa Mita declined to comment.

When working with life settlements, Finra has clearly defined its role as the overseer of variable-life transactions. As of late, the regulator has been busy with enforcement and examinations, and it is investigating a number of reps working with clients who wish to sell their policies, said Jim Shorris, executive vice president and deputy chief of enforcement at Finra.

Areas of principal focus include excessive compensation — the fact that brokers’ pay appears to be closely related to policy size — as well as whether the terms and consequences of the sale were fully disclosed and whether brokers are working to get clients the best price.

However, on the flip side of the transaction, where clients are sold investment interests, the breadth of the regulator’s jurisdiction is murky and would depend on the specifics of the transaction. For example, Finra doesn’t have oversight of universal-life insurance, and where it would stand if a rep recommended that a client invest in such a policy in the secondary market isn’t immediately clear.

LEGAL PRECEDENT

“As with any product, we would apply legal precedent to the particular facts and circumstances to determine whether it’s a security,” Mr. Shorris said, referring to the Supreme Court case SEC v. W.J. Howey Co. The “Howey test” defines an investment contract — or a security — as a contract or transaction in which a person invests money in a common enterprise and is led to expect profits from the efforts of others.

If Finra indeed found such a transaction to be a security, it would be subject to suitability and supervisory requirements, and the firm that permits these types of investments would have to report it to the regulator as an outside business activity.

The circumstances of the sale could also make transaction a security, Mr. Maxson said.

“If you’re brought an investment opportunity and all you’re doing is giving the rep money, and you expect this promoter to manage the investment so that you make the profit, then in that case, it’s likely to be a security,” he said. Of course, he said, that isn’t the same as when a sophisticated investor buys his or her own policies and performs his or her own research — that individual isn’t looking to the efforts of others to reap profit.

But the chain of oversight doesn’t stop there. Firms and reps who recommend that retail investors invest in life settlements need to ensure that they are obeying state securities laws, Mr. Maxson said.

To add another complication, federal laws wouldn’t consider the sale of one entire policy to a single investor to be a securities transaction, but most states do categorize these sales as such. Accordingly, broker-dealers may have requirements in those states to ensure clients’ investments in life settlements adhere to the law.

“Sometimes, there isn’t adequate supervision of the brokers and they sell outside of what the firm allows them to sell,” said Fred J. Joseph, Colorado’s securities commissioner. “Not only would regulators go after the broker, but also after the firm for failure to supervise.”

Clifford E. Kirsch, a partner at Sutherland Asbill & Brennan LLP, said the sale of life settlements in the retail market is “an emerging issue.”

“The appetite has been primarily from the institutional side,” he said.

Major broker-dealers are leery enough of settlements and how state and federal regulators interpret them that they don’t allow their reps to facilitate clients’ investments in them.

“I think firms that permit reps to solicit the purchase of the investment are still held accountable to do a suitability review, notwithstanding the fact that it’s a security — they’re liable in the event of a claim,” said Paul Tolley, the chief compliance officer at Commonwealth Financial Network.

E-mail Darla Mercado at [email protected].