Legal Brief:
Sidney Olmsted and Johanna Olmsted v.
Pruco Life Insurance Company of New Jersey and Prudential Insurance Company of America

No. 00-9511

__________________________________________________________

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

__________________________________________________________

SIDNEY OLMSTED and JOHANNA OLMSTED,

Plaintiffs-Appellants,

v.

PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY and THE

PRUDENTIAL INSURANCE COMPANY OF AMERICA,

Defendants-Appellees.

________________________________________________________

On Appeal from the United States District Court

for the Southern District of New York

________________________________________________________

BRIEF OF THE SECURITIES AND EXCHANGE

COMMISSION, AMICUS CURIAE, SUBMITTED

AT THE COURT'S REQUEST

________________________________________________________

TABLE OF CONTENTS

TABLE OF AUTHORITIES

ARGUMENT

I. The reasonable fee requirement in Sections 26(f) and 27(i)

II. Rescission of unreasonable fees under Section 47(b) of the ICA

III. Remedies under other provisions of the federal securities laws

CONCLUSION

TABLE OF AUTHORITIES

CASES:

Albert Elia Bldg. Co. v. American Sterilier Co., 622 F.2d 655 (2d Cir. 1980)

Aydt v. De Anza Santz Cruz Mobil Estates, 763 F. Supp. 970 (N.D. Ill. 1991)

Basic v. Levinson, 485 U.S. 224 (1988)

BDO Seidman v. Hirschberg, 712 N.E. 1220 (N.Y. 1999)

Canal Insurance Co. v. Ashmore, 126 F.3d 1083 (8th Cir. 1997)

Canal Insurance Co. v. Benner, 980 F.2d 91st Cir. 1992)

Central Adjustment Bureau, Inc. v. Ingram, 786 S.W.2d 28 (Tenn. 1984)

C.J. Roten v. Tesdell & Mackaman, 192 N.W. 442 (Iowa 1923)

Deringer v.Strough, 103 F.3d 243 (2d Cir. 1996)

Hopper v. All Pet Animal Clinic, Inc., 861 P.2d 531 (Wyo. 1993)

Mathers Fund Inc. v. Colwell Co., 564 F.2d 780 (7th Cir. 1977)

Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970)

Nichols v. Anderson, 837 F.2d 1372 (5th Cir. 1988)

Simon DeBartolo Group, L.P. v. The Richard E. Jacobs Groups, Inc., 186 F.3d 157 (2d Cir. 1999)

Simpson v. C & R. Supply, Inc., 598 N.W. 2d 914 (S.D.N.Y. 1999)

Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)

Virginia Bankshares v. Sandberg, 501 U.S. 1083 (1991)

Williams J. Davis, Inc. v. Slade, 271 A.2d 412 (D.C. Ct. App. 1970)

STATUES AND RULES:

Securities Act of 1933, 15 U.S.C. 77a, et seq.:

Section 11, 15 U.S.C. 77k
Section 11(a), 15 U.S.C. 77k(a)
Section 11(e), 15 U.S.C. 77k(e)
Section 12(a)(2), 15 U.S.C. 77l(a)(2)

Securities Exchange Act of 1934, 15 U.S.C. 78a, et seq.:

Section 10(b), 15 U.S.C. 78j(b)
Section 18(a), 15 U.S.C. 78r(a)
Section 29(b), 15 U.S.C. 78cc(b)

Rules under the Securities Exchange Act of 1934, 17 C.F.R. 240.01, et seq.:

Rule 10b-5, 17 C.F.R. 240.10b-5

Investment Advisers Act:

Section 215, 15 U.S.C. 80b-15

Investment Company Act:

Section 26, 15 U.S.C. 80a26
Section 26(a), 15 U.S.C. 80a26(a)
Section 26(e), 15 U.S.C. 80a26(e)
Section 26(f), 15 U.S.C. 80a26(f)
Section 26(f)(1), 15 U.S.C. 80a
Section 26(f)(2)(A), 15 U.S.C. 80a
Section 27, 15 U.S.C. 80a27
Section 27(i), 15 U.S.C. 80a27(i)
Section 27(i)(2), 15 U.S.C. 80a
Section 27(i)(2)(B), 15 U.S.C. 80a
Section 47(b), 15 U.S.C. 80a47(b)
Section 47(b)(1), 15 U.S.C. 80a
Section 47(b)(2), 15 U.S.C. 80a
Section 47(b)(3), 15 U.S.C. 80a
Section 47(b)(3)(A), 15 U.S.C. 80a
Section 47(b)(3)(B), 15 U.S.C. 80a
Section 182(2). 15 U.S.C. 80a

National Securities Market Improvement Act of 1996:

Section 26
Section 27

MISCELLANEOUS:

Corbin, Corbin on Contracts

G. Palmer, Law of Restitution

H.R. Rep. 96-1341

Investment Company Act Rel. No. 17534

Investment Company Act Rel. No. 14190

SEC Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation

Restatement of Contracts (Second) No. 00-9511

__________________________________________________________

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

__________________________________________________________

SIDNEY OLMSTED and JOHANNA OLMSTED,

Plaintiffs-Appellants,

v.

PRUCO LIFE INSURANCE COMPANY OF NEW JERSEY and THE

PRUDENTIAL INSURANCE COMPANY OF AMERICA,

Defendants-Appellees.

________________________________________________________

On Appeal from the United States District Court

for the Southern District of New York

________________________________________________________

BRIEF OF THE SECURITIES AND EXCHANGE

COMMISSION, AMICUS CURIAE, SUBMITTED

AT THE COURT'S REQUEST

________________________________________________________

ARGUMENT

The Securities and Exchange Commission submits this brief in response to the Court's request that it address the issue "whether Sections 26 and 27 of the Investment Company Act (ICA) provide private rights of action."

The Court and the parties have focused on implied rights to damages under Sections 26 and 27 themselves. We believe, however, that the most appropriate private remedy for a violation of the requirement that aggregate fees and charges for variable insurance contracts be reasonable is the express remedy set forth in Section 47(b) of the ICA, which permits rescission of the portion of the contract that establishes an unreasonable price, together with restitution of the excess amounts paid. 15 U.S.C. 80a-46. Section 47(b) permits rescission of any contract that is made or whose performance involves a violation of any section of the Act as well as restitution of the consideration paid for such a contract, subject to the court's equitable authority. In our view, this express remedy would provide complete relief for the violations alleged in this case. In addition, express private remedies under Sections 11 and 12(a)(2) of the Securities Act of 1933, 15 U.S.C. 77k and 77l(a)(2), and the established private remedy under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5, would be available, if the elements of those causes of action are met, though recovery under each of these provisions could involve difficulties that would make the remedy ineffective in this type of case.

Because of the availability and adequacy of the express Section 47(b) remedy, it is not necessary for the court to decide whether there also are duplicative implied damage remedies under Sections 26 and 27, and we take no position on that question. In this connection, we do note that the Supreme Court has expressed reluctance to recognize implied rights of action under statutes that contain express remedies. See Virginia Bankshares v. Sandberg, 501 U.S. 1083, 1104 (1991); Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 19-20 (1979). That reluctance could be particularly pronounced where, as here, there is a rescissionary remedy on the face of the statute that provides adequate express relief for the alleged harm.

We begin with a review of the history of Sections 26(f) and 27(i). We then turn to remedies under Section 47(b) and the other provisions cited above.

I. The reasonable fee requirement in Sections 26(f) and 27(i)

A variable annuity is a contract under which an insurer, in return for a lump sum payment or a series of payments during the "accumulation" period, agrees to make a series of payments to the contract owner for life or for a specified period.¹ Premium payments for variable annuities are allocated to investment portfolios maintained by an insurance company in a "separate account." The value of what the contract owner may ultimately receive depends upon the performance of the separate account into which his or her payments have been invested. Because contract owners assume certain investment risks under the contracts, the contracts are securities under the securities laws and the separate accounts funding the contracts are investment companies under the ICA.

The insurance company charges various types of fees under the contract. This case alleges that the mortality and expenses risk charges under the contracts are unreasonable and that they therefore violate Sections 26(f) and 27(i) of the ICA.²

Before they were amended by the National Securities Market Improvement Act of 1996 ("NSMIA"), Sections 26 and 27 and the rules thereunder restricted variable annuities in ways that created a number of business and regulatory problems because the annuities differed in key respects from the typical investment products covered by these provisions. For example, these sections prohibited mortality and expenses risk charges entirely, absent an exemptive order from the Commission.³ The Commission had attempted to address these problems by adopting exemptive rules and by granting exemptive orders on a case-by-case basis, but these efforts did not entirely eliminate the difficulties.

In 1990, the Commission issued a broad request for comments on reform of the regulation of investment companies. IC Rel. No. 17534 (June 15, 1990). One of the areas as to which comments were sought was whether Sections 26 and 27 should be amended as they applied to variable insurance products. See Section H.1 ("Insurance Products Under the Federal Securities Laws - Variable Insurance Contracts.")

The American Council of Life Insurance (ACLI) submitted an extensive comment letter (relevant sections of the letter are attached hereto at Tab A). The ACLI's principal recommendation was that Sections 26 and 27 be amended to create an exemption from the fee restrictions imposed under those provisions for variable contracts that met certain specified requirements. Specifically, the ACLI proposed adoption of Section 26(e), which would exempt insurance company separate accounts from Section 26(a) if, among other conditions, the insurance company represented in the registration statement for each contract that the charges and fees deducted from the assets in the account "in the aggregate" were either (a) "within the range of industry practice for comparable contracts," or (b) "reasonable in relation to the services rendered, the expenses expected to be incurred and the risks assumed by the insurer." ACLI Letter at 10-11.⁴ The ACLI also proposed to add Section 27(i), which would exempt from Section 27 any separate account funding variable annuity contracts provided that the insurance company "satisfies the conditions in Section 26(e)," including the representation concerning aggregate fees and charges. Id. at 12-13.

The ACLI Letter discussed the private remedies that would be available under its proposal. It observed that under the existing statute, variable contract issuers obtained relief for pricing and distribution issues through individual exemptive orders, and that "contravention of an exemptive order may establish liability for rescission of contracts by virtue of Section 47(b)" of the ICA. ACLI Letter at 50. Under its proposal, it explained,

the inclusion of the representations in the registration statement provides individuals with a potential private right of action pursuant to Rule 10b-5 under the [Securities Exchange Act] for misstatements if actual charge levels deviate from representations. Additional statutory liabilities may exists [sic] pursuant to Sections 11 and 12[a](2) of the [Securities Act] and Section 18(a) of the [Securities Exchange] Act. In addition, contract owners would continue to enjoy the remedies under the current exemptive order mechanism noted above.

ACLI Letter at 51.

Protecting Investors was the report of the Commission's Division of Investment Management that grew out of the request for comments. It recommended amendments to Sections 26 and 27 similar to the ACLI proposal. ⁵ The Division recommended that the insurance company be required to represent that the fees were "reasonable." Also, where the ACLI proposal would have required only that issuers represent that the fees and charges were reasonable, the Division's recommendation added the substantive requirement that those fees and charges actually be reasonable. The Division did not expressly discuss the availability of private remedies, but it did note that under its recommendation, "[i]ssuers would remain subject to the Securities Act and all other provisions of the Investment Company Act." Protecting Investors at 411.

NSMIA substantially adopted the amendments recommended by the Division, adding Section 26(f) (then numbered Section 26(e)), and Section 27(i) to the Act.⁶ Section 26(f)(1) states that Section 26(a), with its restrictions on charges, does not apply to any registered separate account funding variable insurance products, or to the sponsoring insurance company and principal underwriter of such account. Section 26(f)(2)(A) provides, in relevant part, that it shall be unlawful for any registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract "unless the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company and * * * the insurance company so represents in the registration statement for the contract."

Section 27(i), similarly to Section 26(f)(1), excepts variable insurance products from the provisions of Section 27, except as provided in Section 27(i)(2). Section 27(i)(2)(B) provides, in relevant part, that it shall be unlawful for any registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract unless "the insurance company complies with section 26[(f)]."

The effect of these amendments was to replace the prior limitations on mortality and expenses risk charges and other fees with a requirement that the contract not be sold unless the fees and charges under it are reasonable in the aggregate.

II. Rescission of unreasonable fees under Section 47(b) of the ICA

Section 47(b), which was adopted in its current form in 1980, enacts a version of the common law doctrine of "void for illegality." Section 47(b)(1) provides that a "contract that is made, or whose performance involves, a violation of" the Act "is unenforceable by either party * * * unless a court finds that under the circumstances enforcement would produce a more equitable result than non-enforcement and would not be inconsistent with the purposes of [the Act]." Section 47(b)(2) states that to the extent that such a contract has been performed, "a court may not deny rescission at the instance of any party unless such court finds that under the circumstances the denial of rescission would produce a more equitable result than its grant and would not be inconsistent with the purposes of [the Act]." Finally, Section 47(b)(3) provides that the subsection shall not apply "to the lawful portion of a contract to the extent that it may be severed from the unlawful portion of the contract" or "to preclude recovery against any person for unjust enrichment." ⁷

The Supreme Court precedent makes clear beyond reasonable dispute that private plaintiffs may seek rescission of a contract provision charging excessive fees. The principal case is Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979), where the Supreme Court construed Section 215, 15 U.S.C. 80b-15, of the Investment Advisers Act, a provision similar to Section 47(b), to permit rescission and restitution where a contract is contrary to the statute, while at the same time finding no implied right of action for damages under the antifraud provision of that Act. ⁸ The Court explained that the language of the statute "fairly implies a right to specific and limited relief":

By declaring certain contracts void, Section 215 by its terms necessarily contemplates that the issue of voidness under its criteria may be litigated somewhere. At the very least Congress must have assumed that Section 215 could be raised defensively in private litigation to preclude the enforcement of an investment advisers contract. But the legal consequences of voidness are typically not so limited. A person with the power to avoid a contract ordinarily may resort to a court to have the contract rescinded and to obtain restitution of consideration paid.

444 U.S. at 18. Therefore, the statute created the right to sue for "rescission or for an injunction against continued operation of the contract, and for restitution." 444 U.S. at 19. See also Mathers Fund Inc. v. Colwell Co., 564 F.2d 780, 783 (7th Cir. 1977) (pre-Transamerica decision holding that Section 47(b) "contemplates civil suits for relief by way of rescission and for damages"). ⁹

This reasoning applies equally to Section 47(b), as the ACLI Letter recognized. Moreover, Congress was aware of Transamerica at the time it amended the section in 1980 - the legislative history of the bill containing the amendment expressly cites the case in discussing private rights of action. See H.R. 96-1341 at 28 n.6. Indeed, given the explicit language in Section 47(b)(2) that creates a presumption in favor of rescission, the remedy under the current version of Section 47(b) should be viewed as an express rather than an implied one.

A violation of Section 26(f) or 27(i) would clearly give rise to a cause of action under Section 47(b). As noted, those sections make it unlawful for a registered separate account funding variable insurance contracts or a sponsoring insurance company for such account to sell any contract that charges unreasonable fees. Thus, in the language of Section 47(b)(1), a contract containing a provision charging excessive fees would be "made" in violation of the Act, and the "performance" of the contract would "involve[]" a violation.

Section 47(b) gives the district courts broad equitable discretion to order the appropriate remedy for violations. See H.R. Rep. 96-1341, 37 ("The amended section * * * requir[es] a court to examine the equities of the situation and the purposes of the Act in connection with its decision."); see Mathers Fund Inc., 564 F.2d at 783 (relief under Section 47(b) "must * * * be fashioned to comport with, and further the policies of, the overall legislative scheme of which" the provision is a part). In particular, as noted above, Section 47(b)(3)(A) provides that the court should not rescind "the lawful portion of a contract to the extent that it may be severed from the unlawful portion of the contract." Therefore, the proper remedy in the usual case would be to sever and rescind the "unlawful portion" of the contract -- the portion that creates the unreasonable fees -- but to enforce the portion that is reasonable. Restitution of the overcharges could be ordered pursuant to Section 47(b)(3)(B), which expressly permits recovery for unjust enrichment. See H.R. Rep. 96-1341, 37 (subsections (3)(A) and (B) "enunciate equitable principles upon which interpretation and utilization of the present section have been based").

There is little decisional law on rescission under Section 47(b) or the similar provisions in the other securities laws. The approach taken under that section, however, in which the unlawful portion of a contract term may be severed from the lawful part and the lawful part enforced, is consistent with modern contract law as represented by the Restatement (Second) of Contracts (1981). See generally Restatement Ch. 8. We note that the Restatement was adopted shortly after the 1980 amendment to Section 47(b), and that it had been circulating for a number of years prior to that in a draft form that had been treated as authoritative by the courts. ¹⁰

Eschewing the more mechanical approach prevailing in earlier contract law, the Restatement permits courts to exercise their equitable discretion to rescind unlawful parts of a contract in such a way as to effectuate a just result. See Restatement Sections 178 (when a term is unenforceable on grounds of public policy); 183 (when agreement is enforceable as to agreed equivalents); and 184 (when rest of agreement is enforceable).

Of particular relevance here is Section 184, which provides that under some circumstances, a court may treat "part of a term" as unenforceable:

(1) If less than all of an agreement is enforceable under the rule stated in Section 178 [the section that states when a term of a contract is unenforceable on grounds of public policy], a court may nevertheless enforce the rest of the agreement in favor of a party who did not engage in serious misconduct if the performance as to which the agreement is unenforceable is not an essential part of the agreed exchange.

(2) A court may treat only part of a term as unenforceable under the rule stated in Subsection (1) if the party who seeks to enforce the term obtained it in good faith and in accordance with reasonable standards of fair dealing.

Comment b to Section 184 explains that:

Sometimes a term is unenforceable on grounds of public policy because it is too broad, even though a narrower term would be enforceable. In such situation, under Subsection (2), the court may refuse to enforce only part of the term, while enforcing the other part of the term as well as the rest of the agreement. The court's power in such a case is not a power of reformation, however, and it will not, in the course of determining what part of the term to enforce, add to the scope of the term in any way.

The illustrations to Comment b flesh out this guidance. Covenants in restraint of trade that prohibit too many activities (illustration 2) or cover too large a geographic area (illustration 3) are enforceable with respect to activities that could reasonably be prohibited and within a reasonable geographic area. A waiver of liability for "willful or negligent" breach of duty (illustration 4) is enforceable with respect to negligence. And, most pertinently to the issues in this case, a promise to pay an interest rate in excess of the highest permissible legal rate (illustration 5) is "enforceable up to the highest permissible rate" even though "part of the promise" is unenforceable. ¹¹

While Section 47(b) and Section 184 use different terminology, the provisions adopt substantially similar rules. Thus, in relevant part, Section 47(b) states that rescission should be allowed unless the court "finds that under the circumstances the denial of rescission would produce a more equitable result than its grant and would not be inconsistent with the purposes of" the ICA, that the "lawful portion of a contract" may be "severed from the unlawful portion," and only the unlawful portion rescinded, while Section 184(2) provides that a court may "treat only part of a term as unenforceable" if the party seeking enforcement obtained its rights under the contract "in good faith and in accordance with reasonable standards of fair dealing," and if "the performance as to which the agreement is unenforceable is not an essential part of the agreed exchange."

We particularly note that Section 184(2)'s focus on "part of a term" is similar to Section 47(b)'s use of the term "portion of a contract," in that both suggest that the rescission does not have to apply only to an entire "term" or "provision." Decisions under Section 184(2), therefore, appropriately provide additional guidance about the nature of the remedy created by Section 47(b).

In a case decided under state law, this Court endorsed Section 184(2)'s approach to rescission of a "part of a term." Like the first two illustrations cited above, the issue in Deringer v. Strough, 103 F.3d 243 (2d Cir. 1996), was whether a non-compete agreement that could not be enforced as written because it was unreasonable could nonetheless be enforced to the extent that the restrictions imposed were reasonable. ¹² Technically, the case was governed by Vermont law, but there were no Vermont decisions on point. 103 F.3d at 247. This Court therefore considered Section 184(2), as well as its own decisions and decisions of other courts, before concluding that Vermont would "permit enforcement of a defective restrictive covenant to the limit of its validity." 103 F.3d at 247-48 (emphasis added). ¹³ The same principle should be applied to actions under Section 47(b), allowing a court to "permit enforcement" of a fee provision to the "limit of its validity," i.e., to the maximum reasonable amount.

Other courts have also looked to Section 184(2) in deciding to enforce only the portion of a contract term that does not violate public policy. Particularly instructive are a line of cases involving exclusions in insurance policies that were void because they violated state laws requiring insurance up to a specified amount. In each case, the court voided the exclusion as contrary to public policy, but only up to the statutory amount, not to the entire policy amount. Thus, in Nichols v. Anderson, 837 F.2d 1372, 1374-76 (5th Cir. 1988), the court ruled that a clause in an insurance policy limiting coverage to accidents within 150 miles of a certain town was void because it was contrary to a state law requiring common carriers to have $25,000 of insurance coverage. The court applied Section 184(2), which it explained "would adjust the contract as little as possible to enable the parties to have a contract as close to what they originally intended as possible." 837 F.2d at 1376. Therefore, the court voided the geographic restriction "only to the extent required to meet the public policy," which meant up to $25,000, not the full $100,000 provided on the face of the policy. ¹⁴

Courts have also recognized that the power to rescind contracts should be applied so as to do equity on the facts of the case. In Mills v. Electric Auto-Lite Co., 396 U.S. 375, 386-88 (1970), the Supreme Court explained that in selecting the remedy for violation of the Securities Exchange Act's proxy disclosure requirements, courts should exercise the sound discretion which guides the determination of courts of equity, keeping in mind the role of equity as the instrument for nice adjustment and reconciliation between the public interest and private needs as well as between competing private claims. It also noted that the same principles apply in a rescission action under the Securities Exchange Act version of Section 47(b), Section 29(b), 15 U.S.C. 78cc(b).

In other cases, courts have ameliorated the effects of rescission by reducing the amount of restitution ordered for illegal charges by the amounts the defendants could legally have charged. ¹⁵ For instance, in Aydt v. De Anza Santz Cruz Mobile Estates, 763 F. Supp. 970, 975 (N.D. Ill. 1991), the court ruled that the defendant, a landlord, had to return the portion of the rent he had no right to charge but could retain the amount he legally could have charged under the rent-control law. Similarly, in C.J. Roten v. Tesdell & Mackaman, 192 N.W. 442 (Iowa 1923), the court ruled that where a contract between a law firm and a client was void because it provided for an illegal contingency fee, the law firm could retain the reasonable value of its services. ¹⁶

Alternative remedies that could be imagined here, such as voiding the entire contract, voiding only the investor's obligation to pay while requiring the insurer to continue to provide the insurance benefit, or voiding both the obligation to pay and the insurance term, would create precisely the sort of drastic upsetting of the parties' reasonable expectations that led courts and commentators to endorse the more flexible modern approach. Common sense and the statutory language both counsel that only the excessive amount of the fees should be rescinded.

III. Remedies under other provisions of the federal securities laws.

Section 26(f)(2)(A) requires an issuer of a variable annuity contract to represent in the registration statement for the contract that the fees and charges under the contract are reasonable. As noted in the ACLI Letter, if this representation is false, it could give rise to claims under Section 11 and 12(a)(2) of the Securities Act and Section 10(b) and Rule 10b-5 under the Securities Exchange Act.

Section 11(a) of the Securities Act, 15 U.S.C. 77k(a), provides an express damages action against the issuer and various others involved in the offering for material misrepresentations in a registration statement, and there would seem to be no question that, if a person purchases a variable annuity, and the registration statement for that annuity contains the false representation that the fees and charges are reasonable, that person may sue. However, Section 11 contains a restriction on the available damages that could limit the remedy severely. Section 11(e) provides, in relevant part, that a suit under Section 11(a) "may be to recover such damages as shall represent the difference between the amount paid for the security * * * and the value thereof as of the time such suit was brought." Thus, unless the value of the annuity at the time of suit is less than the purchase price, no damages may be recovered. Moreover, Section 11(e) also provides that if the defendant proves that "any portion or all of such damages represents other than the depreciation in value of such security resulting from" the misrepresentation "with respect to which his liability is asserted," then "such portion of or all such damages shall not be recoverable."

Section 12(a)(2) of the Securities Act creates an express remedy for material misrepresentations in a prospectus. The Commission's staff, however, has not interpreted Section 26(f)(2)(A) as requiring that the representation of reasonableness be made in the prospectus portion of the registration statement, and it is our understanding that the representation is typically not contained in that portion. Furthermore, Section 12(a)(2) also contains a restriction on the available damages that could make the remedy ineffective in most cases.

Section 10(b) and Rule 10b-5 provide an already well-established implied cause of action for material misrepresentations made with scienter. Assuming that scienter could be established, an additional difficulty arises from the fact that, as a general matter, proof of reliance is an element of the claim. See, e.g., Basic v. Levinson, 485 U.S. 224, 243 (1988); Simon DeBartolo Group, L.P. v. The Richard E. Jacobs Groups, Inc., 186 F. 3d 157, 173 (2d Cir. 1999). Perhaps a plaintiff who has not seen the registration statement would not be able to claim that he had relied on a false representation in it. On the other hand, it could be argued that investors are reasonably relying on the fact that the law requires the representation to be made in the registration statement as a condition of the legal sale of the security, even though the investor does not actually see the document prior to purchase. Cf. Basic v. Levinson, 485 U.S. at 243-44 ("causal connection" between misrepresentation and injury can be proved in other ways than by showing reliance).

Thus, while a misrepresentation as to the reasonableness of the fees could theoretically give rise to claims under these three provisions, there are substantial practical problems with relying on them to remedy any violations of Sections 26(f) and 27(i).

CONCLUSION

Accordingly, we believe that an action to rescind the illegal portion of the contract under Section 47(b) is the most appropriate remedy under the circumstances. That remedy is express, affords full relief and avoids the legal issues that would be involved in the assertion of an implied right of action for damages under Sections 26 and 27.

Respectfully submitted, DAVID M. BECKER General Counsel MEYER EISENBERG Deputy General Counsel JACOB H. STILLMAN Solicitor MARK PENNINGTON Assistant General Counsel CHRISTOPHER PAIK Special Counsel Securities and Exchange Commission 450 5th Street, N.W. Washington, D.C. 20549-0606 (202) 942-0926 (Paik) December 5, 2001

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