Submitted: January 30, 2014
Martin S. Lessner and Richard J. Thomas, of YOUNG CONAWAY STARGATT & TAYLOR, LLP, Wilmington, Delaware; OF COUNSEL: James P. Gillespie, Jason R. Parish, Michael A. Glick, and John S. Moran, of KIRKLAND & ELLIS LLP, Washington, DC, Attorneys for Plaintiff Aviva Life and Annuity Company.
Brian C. Ralston, Matthew J. O'Toole, and Christopher N. Kelly, of POTTER, ANDERSON & CORROON LLP, Wilmington Delaware, Attorneys for Plaintiff U.S. Bank Trust National Association.
Kenneth J. Nachbar and Kevin M. Coen, of MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware, Attorneys for Defendant American General Life Insurance Company.
Joel Friedlander and Jaclyn C. Levy, of BOUCHARD MARGULES & FRIEDLANDER, P.A., Wilmington, Delaware; OF COUNSEL: Alan B. Vickery, of BOIES SCHILLER & FLEXNER LLP, New York, New York, and Jennifer Altman, of BOIES SCHILLER & FLEXNER LLP, Miami, Florida, Attorneys for Defendants ZC Resource Investment Trust and ZC Resource LLC.
GLASSCOCK, Vice Chancellor
It is a commonplace to note that incentives matter, that imposition of taxes begets exceptions to that imposition, and that the existence of exceptions provides an opportunity for tax adepts to benefit from investments that would not be made, absent the positive tax consequences. This matter involves the tax treatment of life insurance benefits as compensation rather than taxable income. The Plaintiffs contracted with the Defendants for an investment vehicle that would exploit such treatment, and the Defendants have attempted, in the Plaintiffs' view, a unilateral amendment to that contractual relationship detrimental to the Plaintiffs. The Plaintiffs allege that such a unilateral amendment is in breach of the agreements among the parties. The Defendants, on the other hand, view their contractual relationship with the Plaintiffs as mandating a component of the challenged amendment as necessary to preserve favorable tax treatment, and allowing the remaining component under the terms of the parties' agreements. The Plaintiffs seek a declaratory judgment vindicating their view. The issue involves, in part, a question of federal law under the Internal Revenue Code that is of first impression. Ultimately, however, because I find that the Plaintiffs will not be directly affected by the amendment unless contingencies, which may never come to pass, in fact arise, and that the opinion sought would be advisory, I decline to so opine, even under the ripeness analysis appropriate under the Declaratory Judgment Act.
A. The Policies
The insurance policies at issue in this action are corporate-owned life insurance policies ("COLIs"). Before discussing the features peculiar to the specific policies at issue here, I will briefly describe these unusual investment vehicles, on the theory that the reader may find the discussion helpful, as did this bench judge at oral argument. COLIs, sometimes derisively referred to as "janitor policies" or "dead-peasant policies, " provide benefits upon the death of each of what is typically a large number of company employees. The investment works as follows: A large premium is paid at the time the policy is purchased; that premium is then placed in an investment portfolio by the insurer or a third party. Profits generated by the investment of the premium are used to pay a servicing fee, but otherwise accumulate in the investment portfolio associated with the policy. Upon the death of a covered employee, death benefits are paid to the company, which is both the owner and beneficiary of the policy. The size of the death benefit is determined in part by the amount of profits that have accumulated in the portfolio. Typically, these are long-term investment vehicles, as the benefits are not fully paid out for a period of many years, concluding with the death of the last covered employee.
The advantage of such a Byzantine investment structure is that the profits of the investment, paid in the form of death benefits, are free of income or capital gains tax. Therefore, it is of utmost importance to the success of the company's investment that the investment vehicle be treated in such a way that this tax benefit is preserved. If the policies provide for a surrender protocol, the corporate owner of the policy may be able to receive the value of the portfolio containing the premium and accumulated profits upon surrender; such profits, in that case, would be taxable. Such considerations are central to the issues in this case. COLIs, further, are not off-the-shelf products-it is safe to say that most, like the two at issue here, contain terms specifically negotiated by the parties. I now turn to the insurance policies at issue in this litigation.
In October 2000, American Investors Life Insurance Company, Inc. ("American Investors") purchased a COLI from Defendant American General Life Insurance Company ("AGL"), a Texas corporation. American Investors paid an initial premium of $100 million. In June 2001, Indianapolis Life Insurance Company ("IndyLife") also purchased a COLI from AGL, paying an initial premium of $50 million. Both the $100 million and $50 million policies (collectively, "the Policies") were purchased through separate Delaware trusts, for which Plaintiff U.S. Bank Trust National Association ("USBT") currently acts as sole trustee.
After the Policies were purchased, American Investors and IndyLife merged into Plaintiff Aviva Life and Annuity Company ("Aviva"), an Iowa corporation that itself provides fixed indexed life insurance and annuity products nationally.Consequently, Aviva is the sole grantor and beneficiary of the Delaware trusts holding each Policy. The Policies are administered by non-party Benefit Finance Partners, LLC ("BFP"), a Delaware limited liability company.
1. Aviva's Investment
The Policies provide Aviva insurance on the lives of designated employees, which payouts "serve as an informal mechanism for partially funding [Aviva's] employee benefit plans." The value of these Policies "is tied to the performance of the investments to which Aviva allocates its cash value." Here, the Policies' cash value-which was established using the $150 million paid in initial premiums-was allocated to an investment option offered by AGL. Specifically, this $150 million premium was allocated to an AGL "Separate Account, " which is a segregated account comprised of several divisions; each division invests in shares of a corresponding portfolio. Here, Aviva's initial premium payments were directed into the SVP Balanced Division and, correspondingly, invested in the SVP Balanced Portfolio.
The SVP Balanced Portfolio is managed by Defendant ZC Resource Investment Trust ("ZC Trust"), a Delaware trust. Defendant ZC Resource LLC ("ZC Resource, " and together with ZC Trust, the "ZC Defendants"), a Delaware limited liability company, previously acted as a trustee of ZC Trust. Aviva describes ZC Trust, ZC Resource, and BFP as affiliates of non-party Zurich Insurance Company Ltd. ("ZIC"); the ZC Defendants clarify, in part, that ZIC "has a number of subsidiaries in the United States, including [Zurich Benefit Finance, LLC, the current trustee of ZC Trust], which owns an interest in BFP."
After Aviva allocated its $150 million cash value to the SVP Balanced Portfolio, two SVP Balanced Sub-Portfolios were established.  Each SVP Balanced Sub-Portfolio has two components: a securities portfolio and an "SVP Product." The securities portfolio invests in stocks and bonds. Conversely, the SVP Product, a stable value protection component provided by ZIC, is designed "to address fluctuations in the value of the [s]ecurities [p]ortfolio." Accordingly, the book value of each SVP Balanced Sub-Portfolio equals the sum of the values of its securities portfolio and SVP Product, while the value of the SVP Product equals the difference between the book and market values of that Sub-Portfolio.The book value of each Sub-Portfolio, in turn, is set by reference to a crediting rate (i.e. interest rate) set out in the agreements among the parties.
According to Aviva, "[u]nder the original investment terms, the value of the [SVP Balanced Sub-Portfolio] was to grow at a fixed crediting rate to be reset annually pursuant to a formula that would reflect market conditions and amortize . . . the value of the [SVP Product] over time." The SVP Balanced Sub-Portfolios initially had a minimum crediting rate of 0%. As described below, when the Policies were amended in the early 2000s, the minimum crediting rate was increased to 8%.
The parties dispute the purpose of the SVP Product, as well as its impact on Aviva's investment. According to Aviva, the purpose of the SVP Product is to ensure a guaranteed annual return; initially, of 0%-in other words, a guaranteed non-negative return-and later, of 8%. Aviva, in fact, describes the SVP Product as "a guaranty of minimum cash value promised by non-party [ZIC]." To emphasize this understanding, it describes this stable value protection component as an "investment component, " and refers to this product as the "ZIC Guaranty Product, " despite its given name in the transaction documents: the "SVP Product."
Under Aviva's view, the value of the SVP Product, if any, would accrue to Aviva if (and only if) it chooses to abandon the Policies as a tax-free investment vehicle. In other words, upon surrender, AGL would be required to pay Aviva the book value of the SVP Balanced Sub-Portfolios, profit from which would be subject to tax. This payout would necessarily include the value of the SVP Product, if the SVP Product retained any value; that is, if at the time AGL transferred the value of the Sub-Portfolios to Aviva, the Sub-Portfolios' market value was below their book value. The contracted-for timing of that payment, post-surrender, is a matter of contract and is hotly debated by the parties, as is the crediting rate that would apply after surrender.
The Defendants, conversely, emphasize that the SVP Product "is designed and intended to smooth the volatility or market fluctuations in the net asset value of the [securities portfolio], providing accounting benefits only and not an economic return." They refer to a section of the Restated Investment PPMs (defined below), which provides:
[T]he SVP Product will moderate fluctuations in the [net asset value] of the [securities portfolio]. The crediting rates are set by ZIC so that over the long-term, each SVP Sub-Portfolio can be expected to produce a total return equal to that of the [securities portfolio] less the SVP Product Fees.
The Defendants argue that "[c]onsistent with this purpose . . . the total return of the SVP Balanced Sub-Portfolio . . . is expected to converge over the long term to equal the total return of the [securities portfolio] . . . less the SVP Product fees. In other words, the SVP Product is expected to amortize to zero."
The Defendants, further, emphasize that, although "the surrender proceeds may or may not include an amount attributed to the SVP Product as a component, " "there is nothing in the transaction documents requiring AGL to pay the surrender proceeds when the SVP Product value is positive, " and that "payment of surrender proceeds when the SVP Product has been amortized to zero is ...