Securities Law | Expert Legal Commentary

August 24, 2009

Warfield v. Alaniz: Charitable Gift Annuities Found to be Investment Contracts for Securities Law Purposes


By Josh Lawler of Zuber Lawler & Del Duca and Joel Ginsberg

Warfield v. Alaniz: Charitable Gift Annuities Found to be Investment Contracts for Securities Law Purposes

With investors on red alert for Ponzi schemes, the 9th Circuit found that the sales of certain charitable gift annuities (“CGA’s”) were part of one such scheme, and that those CGAs constituted investment contracts subject to securities laws largely because they were marketed as an investment rather than as philanthropy. In Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009), the Court held that the Philanthropy Protection Act of 1995 did not protect either the CGAs or the sales agents who had received commissions for selling the sham CGAs from registration or anti-fraud laws. Mid-America Foundation, the company that originated the sham CGAs, went bust, and the Court enabled a receiver for the defunct company to recover from the sales agents commissions they had received while participating in the scheme.

Background

Between 1996 and 2001, the Mid-America Foundation, run by Robert Dillie and a commissioned sales force, sold what they claimed to be “charitable gift annuities” (CGAs). CGAs are legitimate, widely-used vehicles under which a charity, in exchange for a transfer of cash, marketable securities, or other donor assets, agrees to pay a fixed amount of money to certain individuals (usually over age 60) for their lifetime – those recipients are called “annuitants.” The annuity payments are not considered “income” to the annuitants; rather, they are considered a partial tax-free return of the donor’s original gift, spread over the life expectancy of the annuitant. Upon the death of the annuitant, the balance of the gift (usually intended to be about 50% of the amount originally donated under the contract) goes to the charity. The original gift is given irrevocably and becomes part of the charity’s assets; the annuity payments are considered an obligation of the charity, backed by all of the charity’s assets. Donors typically consider a CGA as a gift to a charity, not an investment, because the total rate of return on a CGA is generally much lower than could be earned through other investment vehicles, including other types of annuities.

Mid-America Foundation sold about 400 CGAs for about $55 million, but it never invested any of the funds. Instead, like a typical Ponzi scheme, the company used new sales to fund annuity payments due previous purchasers and pay company expenses, including covering some of Dillie’s gambling expenses. Very little of the money went to charity. After five years, the Ponzi scheme collapsed, Dillie was convicted and sentenced to more than 10 years in prison, and a receiver was appointed to protect the funds of the annuitants.

The receiver sued the sales agents in federal court in Arizona to recover commissions paid. At trial, the receiver prevailed on the federal and state securities law, constructive fraud, negligence per se, and unjust enrichment claims and Defendants were ordered to pay damages ranging from $31,900 to $109,900 per agent. Defendants appealed. Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009).

The CGAs at issue were investment contracts subject to federal securities laws

On appeal, the defendants agued that the gift annuities were not securities that were subject to securities laws, but the Court disagreed. The Court followed the three-part test for investment contracts set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), requiring: 1) an investment of money; 2) in a common enterprise; (3) with an expectation of profits produced by the efforts of others. 569 F.3d at 1020; SEC v. Rubera, 350 F.3d 1084, 1090 (9th Cir. 2003). The third prong of the test involves two concepts – whether a transaction involves any expectation of profit, and whether expected profits are the result of efforts by someone other than the investor. 569 F.3d at 1020.

The Defendants claimed that donors did not make an “investment of money” because they intended only to make a charitable donation. Moreover, argued the Defendants, the donors had no “expectation of profits” because the anticipated value of the CGAs at the time of purchase was always less than the purchase amount. The Defendants did not dispute that there was a common enterprise or that any profits were the product of efforts of someone other than the investor.

As to the first prong requiring an “investment of money,” Howey requires that the investor “’commit his assets to the enterprise in such a manner as to subject himself to financial loss.’” Rubera at 1090 (Hector v. Wiens, 533 F.2d 429, 432 (9th Cir. 1976)). The investors in this case certainly “turned over substantial amounts of money” in exchange for Mid-America’s promise to make annuity payments and a final payment to a charity; investors risked the possibility that Mid-America would go broke or otherwise fail to continue operations. 569 F.3d at 1021.

Rather than consider the purchaser’s charitable intent, as Defendants argued, the Court looked to see what the purchasers were objectively promised.  Id. at 1022. In this case, Mid-America marketed its CGAs primarily as investments, not philanthropy vehicles, touting its rate of return and emphasizing the income generation and tax savings aspects of the CGA.  “[B]ecause under the terms of the Foundation’s offer, the purchasers of the Foundation’s gift annuities committed their assets in return for promised financial gain, the transactions involved satisfy the ‘investment of money’ prong.” Id. at 1023.

As to the third prong, requiring an “expectation of profits,” the court referred to the Supreme Court’s explanation of this prong in SEC v. Edwards, 540 U.S. 389 (2004), stating that the high Court “used ‘profits’ in the sense of income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment.” 540 U.S. at 394. While the fixed periodic payments in the instant case certainly would qualify under the Edwards definition, the defendants argued that the prong also required that the investors expected some net gain from the transaction, and that in this case, that was impossible.

But the Court disagreed with the defendants on this point as well. Not only could the investor make a profit from the CGA if the annuitant lived longer than the actuarial tables used to define the annuity predicted, Mid-America’s promotional literature specifically touted the CGA as an opportunity for financial gain. For example:

One promotional brochure entitled “Maximizer Gift Annuity: A Gift that Offers Lifetime Income . . . and Beyond” states, under the heading “Attractive Returns,” that “[y]our annuity payment is determined by your age and the amount you deposit. The older you are, the more you’ll receive.” The brochure goes on to list the “current average net-yield” rates. Elsewhere, under a heading titled “A Gift that Gives to the Donor,” the brochure states:

To get this same return through the stock market, [the hypothetical investor] would have had to find investments that pay dividends of 19.3%! (Even the most profitable   companies rarely pay dividends of more than 5%.) The rate of return on a Mid-America Foundation “Gift Annuity” is hard to beat!

The brochure also includes a chart comparing the benefits of a $200,000 commercial annuity with a $200,000 charitable gift annuity, indicating the superiority of the charitable gift annuity in such categories as annuity rate, annual income, income tax savings, federal estate tax savings, and “partial bypass capital gains.” Although the brochure also notes that the investor will “make a difference” through the purchase of the gift annuity, the brochure as a whole emphasizes the income generation and tax savings aspect of the charitable gift annuity. Indeed, a bullet point summary of the advantages of the Foundation’s charitable gift annuities states: “High Rates; Tax Free Income; Capital Gains Tax Savings; Current Tax Savings; Estate Tax Free; Safe; Secure; Simple; Flexible; PAYS YOU NOW!!! HELPS YOU MAKE A DIFFERENCE LATER.”

Id. at 1022. Based on that literature and other facts and circumstances surrounding the sale, an investor could easily anticipate realizing some net profit out of the transaction, and in fact Mid-America specifically presented its CGAs as opportunities for financial gain. Id. at 1024. As a result, the structure of the CGA did include an expectation of profit. Because the CGAs did meet all prongs of the Howey test, the Court determined that they were investment contracts subject to federal securities law. Id.

The Philanthropy Act does not exempt the defendants from registration

The Philanthropy Protection Act of 1995 was passed to codify and clarify certain provisions of the 1933 and 1934 Securities Acts that addressed exemptions from registration for charitable organizations. The Philanthropy Act and subsequent SEC interpretations have assured charities that they can issue gift annuities and other pooled investment vehicles without having to register either the sale of securities or the sales representatives as broker dealers.  The defendants claimed that they were exempt from broker-dealer registration requirements under the Philanthropy Act.

While the Court acknowledged that sales agents for exempt charitable securities sales are generally exempt under the Philanthropy Act, it noted that Congress included a specific provision stating that the exemption shall not apply to anyone unless that person “is either a volunteer or is engaged in the overall fundraising activities of a charitable organization and receives no commission or other special compensation based on the number of donations collected for the fund.” Philanthropy Act, section 4(b) (codified at 15 U.S.C. 78c(e)(2)). Because the Mid-America sales representatives did receive a commission, this provision did not apply and they were not exempt from general securities requirements. Id. at 1027.

The Court did not need to decide whether the CGAs were “exempted securities” under the Philanthropy Protection Act because anti-fraud provisions of the securities laws apply to securities issued by charitable organizations, including those that are exempt from registration requirements. Id. at 1025.

Conclusion

While many charitable organizations rely upon charitable gift annuities as legitimate fundraising vehicles, the Warfield case exemplifies how even charitable vehicles can be used to carry out a Ponzi scheme. In order to protect vulnerable consumers, it is appropriate that charitable gift annuities are not totally exempt from securities laws. As the Warfield case indicates, CGAs are subject to the anti-fraud rules of the securities acts, and individual sales representatives are subject to registration requirements if they are paid on commission. It is notable that this case turned in significant part on the way the CGAs were marketed, focusing more on the income-producing, tax-saving aspect than on the ability to make a meaningful philanthropic contribution. The focus in the marketing materials on the potential profitability of the transaction rather than the philanthropy of it proved key to the outcome of this case.

About the Authors

Joel Ginsberg is Deputy General Counsel at Guidance Software, an industry leader in digital investigative solutions.

View a PDF of the judicial opinion

Connect on Linkedin®

Josh Lawler
Joel Ginsberg

Companies Mentioned

Also See:

Amgen Inc. v. Connecticut Retirement Plans & Trust Funds: Supreme Court Sides with Investors in Securities Fraud Class Action

Gabelli v. SEC: Unanimous Supreme Court Rejects Extending Statute of Limitations in SEC Enforcement Actions

In re Rigel Pharmaceuticals, Inc.: Ninth Circuit Increases Difficulty for Investors to Sue Drug Companies Based on Clinical Trial Results

Mastick v. TD Ameritrade, Inc.: Court Upholds Use of California Arbitration Act in Contracts Governed by California Law

Lawson et al. v. FMR LLC: Sarbanes-Oxley’s Whistleblower Protection Is Limited to Employees of Publicly Traded Companies

The most advanced document                
         management system in the world.

Only $59 / person / month
FeaturesLawLoop Demo
FeaturesWelcome to the Future
Play LawLoop Demo

Companies Mentioned

Securities Law

The following companies are mentioned in Securities Law Updates:

Securities and Exchange Commission

Harris Associates, L.P.

Banc of America Securities LLC

Citicorp USA, Inc.

The Public Employees’ Retirement System of Mississippi

Morgan Stanley & Co., Inc.

Jan Charles Finance S.A.

Park East, Inc.

CIBC World Markets Corp.

Citigroup Inc.

Barclays Capital Inc.

Citigroup Global Markets, Inc.

Guardian Capital Management

ABN AMRO Bank N.V.

Vesta Insurance Group, Inc.

Free Enterprise Fund

Banc of America, N.A.

Torchmark Corp.

Beckstead and Watts, LLP

Barclays Bank PLC

KPMG Peat Marwick, LLP

Deloitte & Touche LLP

Public Company Accounting Oversight Board

BNY Capital Markets, Inc.

Florida State Board of Administration

Credit Suisse Securities (USA) LLC

Credit Lyonnais Securities (USA) Inc.

The Cleaners & Caulkers Local 1 Pension Fund

Credit Suisse, New York Branch

Ameriprise Financial, Inc. f.k.a. American Express Financial Corp.

Deutsche Bank AG

California Department of Corporations

The Royal Bank of Scotland plc

RiverSource Investments, LLC

Harris Nesbitt Corp.

Consolidated Management Group, LLC

The Bank of Nova Scotia

Asset Management Holding AG

Deutsche Bank

Toronto Dominion Texas, LLC f.k.a. Toronto Dominion Texas, Inc.

Alex Brown, Inc.

Tellabs, Inc.

Deutsche Bank Securities, Inc.

Mizuho International PLC

SG Cowen Securities Corp.

Makor Issues & Rights, Ltd.

ABN AMRO Inc.

Lydia Capital, LLC

Suntrust Capital Markets, Inc.

Tribune Company

Additional Resources

Securities Law

Further Reading in Securities Law

Other Recent Expert Legal Commentaries

More Securities Law Expert Legal Commentaries

Recent Summaries

More Securities Law Summaries