Securities Act of 1933 -
|Re:|| Northwest Physicians Mutual Insurance Company
Incoming letter dated April 21, 2003
Based on the facts presented, but without necessarily agreeing with your analysis, the Division will not recommend enforcement action to the Commission if, in reliance on your opinion of counsel that Northwest's surplus contributions are not securities within the meaning of the Securities Act of 1933, Northwest offers and sells the surplus contributions without compliance with the registration requirements of the Securities Act.
This position is based on the representations made to the Division in your letter. Any different facts or conditions might require the Division to reach a different conclusion. Further, this response expresses the Division's position on enforcement action only and does not express any legal conclusion on the question presented.
Kevin P. Hands
April 21, 2003
Via Overnight Delivery
Office of the Chief Counsel
Division of Corporation Finance
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan A. Ingram
Securities Act of 1933 - Section 2(a)(1)
Ladies and Gentlemen:
In accordance with our discussion, this letter replaces our original letter to you dated December 20, 2002 submitted on behalf of Northwest Physicians Mutual Insurance Company (the "Company").
We are securities counsel to the Company, a mutual insurance company organized in 1982 under Oregon law. The Company was organized to provide professional liability insurance to physicians and their associated practices. The Company is authorized to transact the business of insurance in eight states, but presently insures physicians only in the states of Alaska, California, Idaho, Oregon and Washington. The Company is not formed as a risk retention group under the Liability Risk Retention Act of 1986.
To enable the Company to maintain a sufficient surplus to write policies of insurance, the Company proposes to require each of its current members who is an insured physician, and any new physician member, to contribute to the Company's surplus (a "Surplus Contribution") as a condition to remaining or becoming a member and policyholder of the Company. We are requesting that you confirm our opinion that the solicitation and receipt of Surplus Contributions from the Company's members would not be considered an offer or sale of securities under the Securities Act of 1933, as amended (the "1933 Act").
The Company's Surplus Contribution Proposal
In recent years, the Company's losses related to medical malpractice claims have increased significantly. As a result of these losses and corresponding current and projected liabilities, the Company's financial position has weakened.
The financial condition of the Company is measured, in part, by certain leverage ratios. Two principal leverage ratios are the premium-to-surplus ratio and the liability-to-surplus ratio. In essence, these leverage ratios measure whether the Company's surplus is adequate to support the business it writes and the loss reserves it carries. Leverage increases with higher premium revenues, higher loss reserves or decreased surplus. Under these commonly accepted measures, the Company's leverage has increased significantly in recent years as a result of its rate increases, reserve strengthening and decreased surplus. The surplus of the Company provides additional financial security in the event the Company's reserves are inadequate to pay claim costs. The Company believes that its leverage is unacceptably high. By increasing its surplus, through the payment of Surplus Contributions, the Company intends to reduce its leverage to levels the Company believes are more acceptable. If such Surplus Contributions are not obtained, to achieve acceptable leverage ratios, it may be necessary for the Company to reduce its premium revenues by not renewing a significant number of policyholders.
In view of the limited malpractice insurance market in the Western states and the adverse effect nonrenewals would have on physician-policyholders, the Board of Directors of the Company has determined that it is in the best interest of the Company and its members to strengthen the Company's financial position by increasing its surplus funds, and it is proposing that the Company's Articles of Incorporation be amended to require each existing and new insured physician make a Surplus Contribution as described below. Such amendment requires the review and approval of the Oregon Department of Consumer and Business Services.
Each existing insured physician that was a policyholder as of December 14, 2002 (an "Existing Physician Member") will be required to pay a Surplus Contribution based upon the location of his or her practice and/or class of coverage. Existing Physician Members whose primary practice is in Oregon will pay a Surplus Contribution ranging from $4,800 to $6,000 depending on the class of coverage. Existing Physician Members whose state of primary practice is Alaska, California, Idaho or Washington will pay a Surplus Contribution of $3,600. Each physician that becomes a policyholder of the Company after December 14, 2002 but before January 1, 2006 (a "New Physician Member") will pay a Surplus Contribution of $3,600. The Company has reserved the right to modify or eliminate the required contribution for New Physician Members based on their class of coverage. Existing or New Physician Members that practice 25 hours or less per week will be entitled to a 30 percent reduction in their required Surplus Contribution. The Company believes that these Surplus Contributions will increase the Company's surplus by approximately $12,000,000 to $15,000,000. The Company intends to invest the Surplus Contributions received from its members primarily in municipal and corporate bonds or treasuries, with some amount in common equities. Currently, the Company's investments in common equities are approximately 18% and it has no present intention of increasing this proportion. Such investments of Surplus Contributions will be consistent with the Company's current investment policy and managed by its outside investment advisers.
Members would pay the Surplus Contribution to the Company in quarterly installments over a period of three years. The Company will offer a discount of 10 percent of the Surplus Contribution for any Existing Physician Member who pays the Surplus Contribution in full during 2003. No interest will accrue on the unpaid balance of the Surplus Contributions. The payment of the Surplus Contribution will not change the policyholder's voting rights or other membership rights, will not create a liquidation preference in the event of the dissolution, liquidation, merger or reorganization of the Company, and will not result in any entitlement by a physician member to interest, dividends or other income on the Surplus Contribution or to any other dividends or distributions from the Company. The membership interests in the Company and the Surplus Contributions would remain nontransferable. The Surplus Contributions would not be evidenced by certificates.
A policyholder who terminates his or her insurance policy with the Company will not be obligated to pay any further Surplus Contributions that are due after the effective date of such termination. If a physician fails to pay any quarterly installment of the Surplus Contribution when due, such physician's policy will not be renewed on the policy renewal date and such physician may not be eligible for a free extended reporting endorsement (i.e. tail coverage) on the policy. Before denying any such physician free tail coverage, the Company anticipates that it will allow the physician member an opportunity to cure the default.
The Company is not obligated to repay all or any portion of the Surplus Contributions, at any time or under any circumstances. If the Company does not renew or cancels the professional liability insurance policy of a physician member for any reason, any portion of the Surplus Contribution paid by the physician member prior to such nonrenewal or cancellation will not be repaid to the physician. In the unlikely event the Company was sold, demutualized or dissolved, a member-policy holder could receive cash, stock or other property by virtue of membership in the Company, not from the Surplus Contributions.
To succeed, the proposal must be approved by a majority of the Company's members who are present in person or by proxy at a special meeting of members and who are entitled to vote.
The Company's Board of Directors has determined to seek Surplus Contributions from its members in order to (i) reduce the Company's leverage ratios as discussed above, (ii) strengthen the Company's financial condition to make the Company stronger and better able to meet the long-term insurance needs of its members, and (iii) increase the Company's capacity to respond to unanticipated events.
Registration Under the 1933 Act
For the reasons set forth below, it is our opinion that the Board of Directors' proposal to require Surplus Contributions does not involve the offer or sale of "securities," as defined in Section 2(a)(1) of the 1933 Act, and, consequently, that the Company's solicitation and receipt of the Surplus Contributions are not subject to the registration requirements of the 1933 Act.
In general, in the absence of an exemption, the 1933 Act requires a company issuing securities to file with the Securities and Exchange Commission (the "Commission") a registration statement covering the securities. Section 2(a)(1) of the 1933 Act defines the term "security" as follows:
". . . any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights . . . or, in general, any interest or instrument commonly known as a 'security,' or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing."
Insurance policies and membership interests in mutual insurance companies are not listed in the definition; in fact, Section 3(a)(8) of the 1933 Act exempts traditional insurance policies and annuity contracts from registration requirements. Some insurance products, however, may be deemed securities if they possess some of the hallmark characteristics of a security, including substantial investment risk and an expectation of profit. Securities and Exchange Commission v. Variable Annuity Life Insurance Company of America, 359 U.S. 65, 71-73 (1959). Because surplus contributions are not specifically referenced in Section 2(a)(1), the relevant test is whether a surplus contribution falls within one of the definition's two general categories, an "investment contract" or an "instrument commonly known as a 'security.'"
In Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court first articulated the test that is now used for both categories. See Landreth Timber Co v. Landreth, 471 U.S. 681, 691 (1985) (concluding that, although Howey addressed only investment contracts, Howey test applied to "instruments commonly known as a 'security'"). The four elements of the Howey test are: (1) an investment; (2) in a common enterprise; (3) with an expectation of profits; (4) to be derived primarily from the efforts of others. In applying the Howey test, the Supreme Court has emphasized the need to consider "the substance [and] the economic realities of the transaction." United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975).
The first element of the test requires an "investment." The Supreme Court in Howey used a definition of investment from the Minnesota Supreme Court: ". . . the placing of capital or laying out of money in a way intended to secure income or profit from its employment." The Surplus Contributions, which represent only a contribution to the surplus of the Company, do not in any way represent an "investment." The Surplus Contributions do not bear interest, are nonrefundable and will not provide income or profit.
The third element, "expectation of profit," has been defined by the Supreme Court in Forman as (i) capital appreciation resulting from the development of the initial investment or (ii) participation in earnings resulting from the use of investors' funds. By contrast, however, when a purchaser is motivated by a desire to use or consume the item purchased, the securities laws do not apply.
Here, the proposed Surplus Contributions (i) would not accrue interest for the benefit of members nor entitle contributing members to dividends, (ii) would not entitle the member to a reduction or return of premium, nor (iii) otherwise create a potential for profit. The Surplus Contributions are not transferable, and the members would have no right to reclaim any amounts contributed. Further, any return earned from investment of the Surplus Contributions would be added to the Company's surplus for payment of losses or claims, not returned to any member. Any amounts returned if the Company was sold, demutualized or dissolved, would be by virtue of membership in the Company, not from the Surplus Contributions. Moreover, as stated in Forman, "speculative and insubstantial" profits are insufficient to bring a transaction within the definition of a security. When a profit-producing purpose is incidental, the item will not be considered a security. In the case of the Company, any potential for profit is attenuated and theoretical, and is not a motivating factor for the member making a Surplus Contribution.
Members making Surplus Contributions are motivated by the desire to continue to use or to purchase insurance policies with the Company, with such contributions being designed to provide a sound financial basis for the Company to withstand unexpected contingencies. There is no anticipation of income or appreciation in value on the members' part. From the standpoint of a member, the Company is viewed solely as a source of malpractice insurance. In short, contributing members are not motivated by profit, but rather a desire to maintain insurance policies issued by the Company or, in the case of future members, to obtain new insurance policies. For these reasons, we believe that the Surplus Contributions do not involve an "expectation of profits" within the meaning of Howey.
The Surplus Contributions, therefore, fail to meet at least two of the essential parts of the Howey test: (i) an investment (ii) that is made with an expectation of profit. Accordingly, under Howey and its progeny, it is our opinion that the proposed Surplus Contributions do not involve the issuance of securities for purposes of Section 2(a)(1) of the 1933 Act.
Further, it is our opinion that the Supreme Court's decision in Reves v. Ernst & Young, 494 U.S. 56 (1990), is inapplicable to the Company's situation due to its factual dissimilarities. The Court in Reves considered whether promissory notes issued by a farmers' cooperative constituted "notes" under the Securities Exchange Act of 1934 (the "1934 Act") definition of a security. Because "notes" are specifically referenced in the definition of a security, the Court believed that "notes" should be presumed to be securities unless proven otherwise. The Court in Reves did not apply the Howey precedent and stated that the holding in Howey was limited to determining whether an instrument fit the catchall category of an "investment contract." Id. at 64. As discussed above, because the proposed Surplus Contributions are not specifically referenced in Section 2(a)(1) of the 1933 Act, the relevant test is whether they fall within one of the definition's two general categories, an "investment contract" or an "instrument commonly known as a 'security.'" Accordingly, it is our view that Howey, and not Reves, is the appropriate test to apply.
However, if the Reves analysis were applied to the proposed Surplus Contributions, the Surplus Contributions would not be considered securities. The Court in Reves applied the "family resemblance" test, which consists of four factors to decide whether instrument in question is a security:
First, the transaction in which the interest was received must be evaluated to determine the motivations of the parties involved. "If the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a 'security.'" Id. at 66. Second, the "plan of distribution" must be examined to determine if it is an instrument in which there is trading for speculation or investment. Third, the "reasonable expectations of the investing public" with respect to the interest must be examined. The Court stated that the marketing efforts of the seller are relevant in determining the expectations of the investing public, i.e., whether the seller advertised the interest as an investment. Fourth, the Court noted that application of the 1933 Act is unnecessary if an alternative regulatory scheme exists that would significantly reduce the risks associated with the transfer of the interest alleged to be a security. Id. at 67.
Under the four criteria enunciated by the Supreme Court in the Reves case, the proposed Surplus Contributions do not constitute the issuance of securities. First, as discussed above, a member would not make a Surplus Contribution with an expectation of receiving a profit, especially because the Surplus Contributions cannot be transferred, will not accrue interest and will not entitle members to dividends. The motivation for a member is the desire to continue to have access to reasonably priced medical malpractice insurance from an insurer that will continue to be in existence for the long-term and whose financial resources will allow it to cover unanticipated events in the medical malpractice market.
The second factor, the "plan of distribution" factor, examines whether the Surplus Contributions are an investment in which there is a common trading market for speculation or investment. Here, the Surplus Contributions are not being offered or sold to the public generally, but only to the present and future members of the Company, of which existing members have joined for malpractice insurance purposes over the last twenty years. Participation in the Company is limited to those practicing medicine, and is not available to the public generally. Also, since the Surplus Contributions are neither freely tradable nor transferable, no secondary market exists or will exist with respect to such contributions. A member's Surplus Contribution earns no dividends or interest, so not only is there no public market, there is also a lack of return and a lack of an opportunity to realize appreciation. The Surplus Contributions would be of no interest to an "investor" or to the general public. This is a commercial insurance arrangement, not an investment scheme.
Third, the reasonable expectations of those making Surplus Contributions are to continue to be able to receive or to obtain medical malpractice insurance, not a return on an investment. Again, no interest is paid, no dividends are earned and no appreciation occurs from the Surplus Contributions. In addition, the purposes identified for making the Surplus Contributions do not characterize them as investments: (i) the need to reduce the Company's leverage ratio as discussed above, (ii) to strengthen the Company's financial condition to make the Company stronger and better able to meet the long-term insurance needs of its members, and (iii) to increase the Company's capacity to respond to unanticipated events. All of such reasons relate to the continued provision of malpractice insurance, the commercial product marketed by the Company.
Lastly, the Company is also subject to regulation by the insurance regulatory authorities, which provides additional oversight and protection for members, thereby decreasing the need to rely on the 1933 Act. The Company is subject to pervasive regulation by the Oregon Department of Consumer and Business Services. The Company's solvency is monitored utilizing various regulatory measures. The Company's financial condition is reported quarterly in accordance with statutory insurance accounting principles. The Company's regulatory compliance is monitored by periodic financial examinations and market conduct examinations. All significant transactions of the Company are subject to regulatory approval. The Oregon insurance regulatory scheme monitors the Company and its actions, thereby serving as a regulatory risk-reducing mechanism.
Therefore, even if the Reves analysis were assumed to apply to the Company's situation, it is our opinion that the proposed Surplus Contributions do not meet its definition of a "security" under the "family resemblance" test.
Our conclusion is supported by a long line of no-action letters in which the staff of the Commission's Division of Corporation Finance (the "Staff") has agreed that capital contributions or reserve premiums paid to mutual insurance companies do not involve the sale of securities, including situations where members had on-going obligations to make such contributions or payments. See Cal Accountants Mutual Insurance Co., SEC No-Action Letter (November 16, 1988) (offer and sale by mutual insurance company of certificates of contribution representing interests in mutual insurance company and evidencing capital contributions in such insurer does not fall within the definition of a sale of a security under Section 2(a)(1)); Attorney's Liability Assurance Society, Ltd., SEC No-Action Letter (February 12, 1979) (sale by mutual insurance company of membership interests and insurance coverage, which require reserve premiums, did not require registration under the federal securities laws); Global Van Lines, Inc., SEC No-Action Letter (October 2, 1979) (sale by not-for-profit insurance corporation of membership interests and insurance coverage, which included the possibility of retrospective premiums, did not require registration under the federal securities laws); Medical Device Mutual Assurance and Reinsurance Co., Ltd., SEC No-Action Letter (August 31, 1979) (sale by mutual insurance company of membership interests and insurance coverage, which included callable premiums, did not require registration under the federal securities laws); Norcal Bowling Proprietors Mutual Insurance Co., Ltd., SEC No-Action Letter (December 5, 1983) (sale by mutual insurance company of membership interests and insurance coverage, which require reserve premiums, did not require registration under the federal securities laws); Podiatric Assurance Co., SEC No-Action Letter (February 19, 1985) (offer and sale by mutual insurance company of membership interests and insurance coverage, which require membership contributions, did not require registration under the federal securities laws); The Dentists Insurance Co., SEC No-Action Letter (September 10, 1987) (offer and sale of certificates of contribution evidencing capital contributions in insurer did not require registration under the federal securities laws); Medmarc Insurance Company Risk Retention Group, SEC No-Action Letter (October 2, 1987) (the Staff's response letter stated that the sale of membership interests and insurance coverage by a mutual insurance company that was not a risk retention group did not involve the purchase or sale of securities, but that the sale of membership interests and insurance coverage by a mutual insurer that was a risk retention group may involve the sale of securities); National Transport Assurance Alliance, Inc., SEC No-Action Letter (February 22, 1989) (offer and sale by insurance company of membership interests and insurance coverage, which include annual reserve premiums, did not require registration under the federal securities laws); Construction Trade Purchasing Group, Inc. and Construction Trades Insurance Company, SEC No-Action Letter 1008 (October 1, 1993) (sale by a captive insurance company of membership interests and insurance policies, which include reserve premiums, did not require registration under the federal securities laws).
For the reasons set forth above, we respectfully request on behalf of the Company that the Staff (i) concur with our opinion that the Surplus Contributions do not involve the issuance of securities and (ii) not recommend any enforcement action if the Company receives the Surplus Contributions without complying with the registration provisions of the 1933 Act.
If the Staff is unable to concur with our opinion, or should any additional information be desired in support of the Company's position, we would appreciate an opportunity to confer with the Staff concerning these matters.
Seven additional copies of this letter are enclosed in accordance with Securities Act Release No. 6269 (December 5, 1980). If you have any questions regarding any aspect of this request, please feel free to call the undersigned at (503) 802-2049 or Thomas P. Palmer of our office at (503) 802-2018.
Very truly yours,
/s/ Sherrill A. Corbett
Sherrill A. Corbett
cc (w/encls.): Thomas P. Palmer, Esq.
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