LIFE SETTLEMENTS: SUMMARY OF RECENT DEVELOPMENTS
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1 WEALTH MANAGEMENT: SPECIAL REPORT Minimize taxes Provide for family Form family offices Manage trusts Administer estates LIFE SETTLEMENTS: SUMMARY OF RECENT DEVELOPMENTS In This Report Page Develop business succession and liquidity plans Protect assets Manage philanthropy Examine alternative investments Recent Cases: o Incontestability Trumps Fraud 1 o Incontestability May Not Overcome Insurable Interest.. 3 Texas Enacts Settlement Legislation.. 3 IRS Responds to Settlement Taxation Inquiry 5 RECENT CASES INCONTESTABILITY TRUMPS FRAUD Decisions in two recent cases, Settlement Funding v. AXA Equitable 1 and The Lincoln Life and Annuity Company of New York v. Berck, 2 have found that the expiration of a life insurance policy s contestability period prevents a life insurer from rescinding a policy, despite misrepresentations and fraud in the policy applications. In Settlement Funding, a trust applied for and acquired a $5 million policy insuring an Ohio resident. The policy was issued by AXA Equitable on May 11, At the time of policy issuance, the trust beneficiaries included the insured s two daughters and a sonin-law. On January 29, 2009, the policy was sold to Life Settlement Corporation (LSC) for $750,000. In spring 2009, however, LSC began negotiations to unwind the original settlement. During this process, the insured died. Two days later, the trust paid $1 million to LSC to re-obtain the policy (representing the original purchase price plus an additional premium paid on the policy). On July 6 th, the trust filed a claim for the proceeds. LSC also filed a claim on July 15 th. AXA brought suit in Ohio to declare the policy invalid. Settlement Funding (a related entity to LSC) filed suit in New York to obtain the policy death benefits. The Ohio suit was dismissed, and AXA agreed to a jury trial to hear the New York action. AXA alleged that the policy was obtained through fraud, including misrepresentations in the application regarding the insured s net worth, existing coverage on her life, and the intention to subsequently sell the policy on the life settlement market. In a jury trial, however, the jury found that the policy s contestability clause (which typically provides that a policy become incontestable after being in force for two years) U.S. Dist. LEXIS 28798, U.S. Dist. Ct., Southern Dist. of New York (March 23, 2011). (Unpublished) Calif. 4th Dist. Ct. of Appeal (Div. One), Case No. D (May 17, 2011). TCO v2 July 19, 2011 GREENBERG TRAURIG, LLP ATTORNEYS AT LAW
2 time-barred the insurer s claims that the policy should be voidable or rescindable based on these fraudulent misrepresentations. The jury s decision is in keeping with prior New York law, which provides a particularly high threshold for an insurer to overturn a policy after expiration of the contestability period. For example, prior New York case law has prohibited an insurer from voiding a policy after passage of the contestability period even when based on the claim that the policy lacked an insurable interest at inception. In the Berck case, the California Court of Appeals overturned a prior California Superior Court decision voiding two $10 million policies due to a lack of an insurable interest at inception. The facts of this case involved an apparent beneficial interest deal, where the insured established a trust to hold the policies for the benefit of his children. The children almost immediately after policy issuance sold their interest in the trust to a third-party investor. Similar to the Settlement Funding case, the carrier alleged that there were significant misrepresentations in the application (e.g., regarding the insured s net worth and the intent to sell the policies) and pervasive fraud. While the Superior Court agreed that there were egregious misrepresentations and fraud, it held that the misrepresentation claims would be barred by the policies incontestability clauses. The Superior Court found, however, that there was no insurable interest at inception of the policy, since under the beneficial interest structure used to acquire the policies, the investor actually bought the policy, not the trust. Accordingly, the policies were void from inception, making the decision regarding the incontestability clause moot. The Court of Appeal reversed the Superior Courts insurable interest decision, finding that insurable interest did exist in these polices, based on California law as it existed at the time of the policy issuance. The trust had an insurable interest in the insured at policy issuance, because it was created by the insured and benefited his children. Accordingly, the Court of Appeal ruled that the trial court erred by ruling the policies are void ab initio because of the absence of an insurable interest. The Court of Appeal, however, upheld the Superior Court s finding that the misrepresentation claims were barred by the incontestability provision. Thus, the carrier could not rescind the policies based on either insurable interest or misrepresentation claims. These decisions are important for the life settlement market and likely provide some comfort to investors that acquired now incontestable policies in prior settlement transactions. Note, however, that insurers may provide specific exceptions or carve-outs to a policy s contestable clause, including for fraud or misrepresentations in the application. Such carve-outs may become more common in policies, in light of these decisions. Thus, each policy s contestability clause must be carefully analyzed to determine the scope of the provision and the extent of the policy s owner s exposure to future claims. These cases, however, may have little precedential impact on recently issued policies. Both New York and California (as well as a majority of other states) now regulate life settlements and specifically prohibit so-called stranger originated life insurance (STOLI) transactions, which were designed to initiate policies for the benefit of third-party investors. Accordingly, these cases generally will not support a resurgence of STOLI transactions or an increase in the settlement of newly-issued policies. INCONTESTABILITY MAY NOT OVERCOME INSURABLE INTEREST On July 6, 2011, a federal judge refused to dismiss a carrier s rescission action, holding that Illinois law does not bar carrier challenges based on lack of insurable interest even if the policy s contestability period has expired. 3 In this case, Ohio National Life Assurance Corporation brought suit against several individuals and trusts for perpetuating an alleged STOLI scheme. Ohio National alleged that these individuals solicited senior citizens to purchase life insurance policies through trusts in exchange for cash payments. Beneficial interests in the trusts were later sold to third party investors. 3 Ohio National Life Assurance Corporation v. Davis, et. al., U.S. Dist. Ct., Northern Dist. of Illinois (Eastern Div.), Case No. 10C2386 (July 6, 2011). GREENBERG TRAURIG, LLP ATTORNEYS AT LAW [2]
3 Ohio National seeks to rescind or void these policies, based, in part, on claims that the policy applications contain misrepresentations and fraudulent statements regarding the seniors net worth and knowledge of the transaction, and that the policies lack insurable interest. An investor brought a motion to dismiss Ohio s claims against his policy, arguing that insurable interest existed at the policy s inception and that Ohio National was time-barred from rescinding the policies due to expiration of the policy s contestability period prior to Ohio National s filing of its complaint. The court, however, refused to dismiss Ohio National s action against the policy, stating that given Illinois s unwavering prohibition on wagering contracts, it is no surprise that an incontestability provision cannot stand in the way of the insurer seeking to rescind a policy for lacking an insurable interest. Thus, the court found that Illinois prior case law supported the proposition that when the allegations in the complaint plausibly establish a lack of insurable interest, then the incontestability provision does not prevent the insurer from challenging the policies. The key point here is the dramatic difference in litigation outcomes that may occur depending on which state law applies to a settlement transaction. Compare this case to New York law, as noted above, which bars insurable interest challenges after expiration of a policy s contestability period. Thus, when assessing the potential exposure of a settled policy to challenge, it is critical not only to review the specific terms of the policy s incontestability provision, but also to consider which claims will be barred by the passage of the contestability period under applicable state law. Policies that no longer face either insurable interest or fraud challenges will likely be of higher value in the secondary market. TEXAS ENACTS SETTLEMENT LEGISLATION As Texas has some of the most liberal insurable interest laws and previously did not regulate life settlements, it was often a preferred jurisdiction for many life insurance policies involved in life settlement transactions. On June 17 th, however, Texas enacted comprehensive life settlement legislation based on the National Conference of Insurance Legislators (NCOIL) Model Act, which prohibits a person from entering into a life settlement within two years of issuance of a life insurance policy. 4 Notably, this legislation also: Provides limited exceptions to the two-year ban on life settlements, including for changes in the owner/insured s financial or medical circumstances or where the owner or insured disposes of closely-held business interest pursuant to the terms of a buyout or similar agreement in effect when the policy was issued. Defines life settlement contract to include transfers of beneficial interests in an entity holding a life insurance policy (designed to capture beneficial interest deals). Excludes from the definition of a life settlement a bona fide business succession planning arrangement between shareholders and/or their corporation, partners and/or their partnership, and LLC members and/or their LLC, or trusts established by any of them. Requires that fees paid to brokers be computed as a percentage of the offer, not the face value of the policy. Requires settlement providers and brokers to be licensed and to comply with various licensing pre-requisites. o Note that, unlike the NCOIL, the Texas legislation s definition of broker includes a person who estimates life expectancies for a life settlement contract. Thus, life expectancy providers may have to register as brokers in Texas and comply with many of the licensing requirements. Persons acting solely as life expectancy estimators, however, are specifically excluded from broker continuing education 4 See Bill HB GREENBERG TRAURIG, LLP ATTORNEYS AT LAW [3]
4 requirements, making the required broker disclosures to the policy owner, and certain compensation restrictions applicable to brokers (e.g., compensation as a percentage of the offer amount). Allows insurance agents who have been licensed in Texas for one year to act as brokers without meeting certain broker licensing requirements if they notify the commissioner within 30 days of so acting and pay a set fee. Requires brokers to disclose to owners that there may be alternatives to or potential tax consequences from a settlement, the proceeds could be subject to creditor claims, and other disclosures required under the NCOIL Model. Providers are only required to make these disclosures if no brokers are involved in the transaction. Allows an insurer to ask in the application whether the owner intends to pay premiums with the assistance of financing from a lender that will use the policy as collateral. If the loan provides funds that can be used for purposes other than premiums, the carrier can reject the application. Otherwise, the carrier may require additional disclosures or certifications in connection with the policy application and the financing. Requires insurers to respond to a request for verification of coverage within 30 days, either verifying coverage or indicating why not and whether it intends to pursue an investigation regarding the policy s validity. Prevents insurers from unreasonably delaying a change of ownership or beneficiary for a lawful life settlement contract entered into in Texas or with a Texas resident. Provides for a 30-day rescission period. Requires a provider to notify the issuing carrier that a policy has become subject to a life settlement contract within 20 days of the policy owner s execution of the settlement contract. Requires providers to report annually on (1) the total number, aggregate face amount, and life settlement proceeds of policies settled during the calendar year, with a breakdown of the information by policy issue year, (2) the names of the carriers that issued the policies and (3) the brokers that settled the policies. Note that the reporting is limited to transactions in which the insured is a Texas resident. Requires a provider or broker to implement antifraud initiatives reasonably calculated to detect, prosecute, and prevent fraudulent life settlement acts, which must include: o Fraud investigators (may be employees or independent contractors); o An antifraud plan submitted to the commissioner, which describes the procedures for (a) detecting, investigating and reporting possible fraudulent life settlement acts and (b) resolving material inconsistencies between medical records and insurance applications; o A description of the plan for antifraud education and training of underwriters and personnel; and o A description or chart outlining the organizational arrangement of the antifraud personnel. The legislation takes effect on September 1, IRS RESPONDS TO SETTLEMENT TAXATION INQUIRY On May 3, 2011, Pennsylvania Senators Robert P. Casey, Jr. (D) and Patrick J. Toomey, Sr. (R) sent a letter to Treasury Secretary Timothy Geithner requesting clarification regarding the income taxation of life settlements, specifically as GREENBERG TRAURIG, LLP ATTORNEYS AT LAW [4]
5 outlined in Revenue Rulings and The Senators stated that Rev. Rul imposes a different tax standard on the sale of a life insurance policy to a third party than on the sale or surrender of the policy to the issuing carrier. Specifically, the Senators noted that a sale to a third party requires the initial policy owner to deduct the cost of insurance (COI) from his or her tax basis when determining his or her taxable income, while no such requirement is imposed when the owner surrenders the policy. Although two policies may have identical death benefits and cash surrender values, they may have different COI charges and crediting rates. In such a case, a policy owner would face the same tax consequences with regard to both policies upon surrender but different tax consequences upon a sale. Further, the Senators noted that Rev. Rul imposes disparate tax consequences on policy owners who purchased their policies in life settlements. To the extent the purchaser receives amounts in excess of the consideration and premiums paid by the purchaser for the policy, such excess amounts are taxable as ordinary income if received as a policy death benefit and as capital gain if received as sale proceeds from a sale of the policy. The Senators asked for clarification of these disparities, citing their concern that this differing treatment could lead to inefficiencies in the secondary market and reduce the capital available to buy policies, thereby hindering opportunities for seniors to maximize their policy values. In a response letter sent on June 1, 2011, the Treasury Department attempted to justify these disparities. With regard to the differing tax treatment of a policy surrender and a sale, Treasury noted that a surrender is statutorily governed by Code 72(e), while a sale is governed by general tax principles and case law. According to Treasury s interpretation of such principles and case law, COI charges represent the value of insurance coverage already paid for and provided to the policy holder before the sale, and thus should not be attributable to the remaining portion of the contract that is to be sold. With regard to the receipt of death benefits by a purchaser of a settled policy, Treasury stated that these benefits are ordinary income because they are received under the contract and not pursuant to a sale or exchange, which is a pre-requisite for capital gain treatment. It noted that, in contrast, the proceeds received by the third party purchaser upon a sale of a policy are treated as capital gain because the policy was a capital asset that was sold or exchanged. Many practitioners and commentators noted these potential tax disparities when the Revenue Rulings were originally issued and continue to believe that the IRS conclusions regarding life settlement taxation are questionable in certain respects. Treasury s response, however, does little to resolve or clarify these issues. Rather, it simply re-states its reasoning as presented in the Revenue Rulings. Legislative action or a judicial decision supporting or overruling the IRS position likely will be required in order to obtain additional clarification or final resolution of these questions. Wealth Management Group, Greenberg Traurig LLP, Tysons Corner Office: Jonathan M. Forster forsterj@gtlaw.com Todd I. Steinberg steinbergt@gtlaw.com Rebecca S. Manicone maniconer@gtlaw.com GREENBERG TRAURIG, LLP ATTORNEYS AT LAW [5]
6 Carmen Irizarry-Díaz Valentina Minak Jennifer M. Smith Other GT Offices: Albany Amsterdam Atlanta Austin Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Palm Beach County North Palm Beach County South Sacramento Shanghai +86 (21) Silicon Valley Tallahassee Tampa Tokyo +81(3) Tysons Corner Washington, D.C White Plains Disclaimers: This Greenberg Traurig Special Report is issued by the Tysons Corner Wealth Management Group for informational purposes only and is not intended to be construed or used as general legal advice. This information cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on such taxpayer. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. Financial Disclaimer. The projections and illustrations provided in the examples are hypothetical approximations only, based on various factual, actuarial, and tax assumptions. Actual results will vary and cannot be guaranteed. Greenberg Traurig, LLP does not provide investment advice. Circular 230 Disclaimer. Pursuant to U.S. Treasury Department Circular 230, the tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another party any matter(s) addressed herein. GREENBERG TRAURIG, LLP ATTORNEYS AT LAW [6]
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