The
insurer candidly states that, at present, it can increase its capital
only through retained surplus contributed by its business or by selling
surplus notes. (Equitable
already has sold and leased back its headquarters office building.)
Equitable admits that neither of these sources of capital is
adequate because its business has not generated substantial surplus,
accumulations, and surplus notes do not provide permanent capital
to the company. Hence, raising equity capital is the only solution.
Moreover,
the demutualization process unlocks the equity interests of policyholders
who are demanding more value from their insurers, providing them a
payment (which may be in several forms) for their mutual owner interest. It also permits policyholders to continue to
participate in the equity of the company by acquiring the company=s common stock in the conversion.
The demutualization process can be viewed as a journey during
which the company is transformed into a modern, publicly owned corporation,
structured in the form used by most other insurance companies as well
as other financial services providers.
STICK
WITH THE DIRECT ROUTE
While
several methods are available to achieve the stock form of organization,
the most direct route is usually the best.
As of the spring of 1991, 41 states had statutes on the books
to permit life or property casualty insurers (usually both) to convert
directly to stock form. Two
states, Alaska and Hawaii, prohibit direct demutualization and seven
states (Connecticut, Illinois, Massachusetts, Mississippi, Missouri,
New Hampshire and North Carolina) do not have a direct conversion
law.
The
legislatures in Connecticut and Massachusetts have, on occasion, passed
special acts to effect the demutualization of certain companies. (For example, on June 2, 1981, the Massachusetts
legislature passed a special act authorizing the conversion of Worcester
Mutual Insurance Co. to a stock insurance company.) Those acts generally contain provisions similar
to the demutualization laws in other jurisdictions.
Because
each state has put its own spin on the Amodel
demutualization act,@
it is practical, for purposes of this discussion, to choose only one
state=s law as a basis for developing
a plan of demutualization. The
New York statute is a logical choice because it is the most comprehensive
of the relevant laws that so far have been enacted and because the
Equitable is the first to use it to demutualize. Not all state laws are as stringent as the New York statute; indeed
most laws require substantially less.
But the New York law is good for instructional purposes, since
it seems to touch on almost every conceivable aspect of a demutualization.
Although the New York statute provides a company with alternative
structures for the conversion transaction, this article focuses on
the most complex structure.
The
New York law is significant in another regard.
Compared with it, most state statutes essentially are barebones
prescriptions, providing little or no guidance for the various state
insurance departments, except to indicated that the plan
of demutualization must be Afair
and reasonable.@ Moreover, many state insurance departments
have yet to promulgate regulations on the preparation of a plan of
demutualization or the manner of conducting the corporate conversion
to stock form. Therefore,
the New York provisions may provide guidance to other states when
insurers in their jurisdictions demutualize.
What
has been called a Aplan
of demutualization,@
Aplan of conversion@ or Aplan of reorganization@ is the most important document in the entire
transaction. The plan of demutualization
is more than just the road map to the deal: It is the company=s opportunity to structure the future of the
firm. An outline of what the
statute states the plan must accomplish illustrates the steps involved
in implementing the demutualization.
The statute states that the plan must demonstrate a purpose and specify reasons for the proposed reorganization, be in the best interest of the mutual life insurer and its policyholders and be fair and equitable to policyholders. In addition, it must provide for the enhancement of the operations of the reorganized (now, stock) insurer, and it must not substantially lessen competition in any line of insurance business.
NUTS
AND BOLTS
These
lofty mandates, or statutory goals, are well and good and demand compliance,
but they do not deal with the nuts and bolts of the plan of demutualization.
The plan must express how the transaction is to be accomplished;
in short, it must show who gets what. In substance, the plan sets forth the procedures
by which the company will comply with the basic requirements of the
law.
There
is no cookbook method for producing a plan.
Each company will have to determine, under governing law and
regulation, what will be the most effective way to convert to a stock
company. However, the following hypothetical plan sets
forth the major points that should be considered in any demutualization
process.
The
first, introductory, section of the plan should summarize the background
of the demutualization by briefly reciting the history of the company,
when it was founded, its current form of organization and its financial
condition. The second section, in recognition of the complexity
of the process, usually contains definitions of the terms and abbreviations
used in the body of the plan.
Section
three of the plan should provide the reasons for the demutualization. The obvious reason is to increase the company=s
surplus. However, companies
offer more sophisticated goals. In
1986, for example, in the first major demutualization, UNUM Corp.
cited as its reasons for converting to stock form the following:
to provide policyholders with the opportunity to convert their
illiquid membership interests in the mutual insurer into marketable
securities or cash; to enable the insurer to raise additional capital
to support and expand operations; to enhance opportunities for acquisitions,
including the opportunity to offer its publicly traded stock to shareholders
of acquired companies; and to make stock or stock rights available
as incentives for its employees.
Other companies have rationalized the process to include the
ability to sell control of the company to an investor, to fund expansion
into new product lines and to expand existing lines of business.
CONDITIONS
FOR IMPLEMENTATION
The
fourth section of the plan should discuss the procedural conditions
for implementing the plan. Among
the conditions that must be met are the approval of the plan by a
supermajority vote (in New York, three-fourths) of the board of directors. In addition, eligible policyholders must be
notified about the plan and vote on it.
In New York, notice of a vote of policyholders to approve the
plan must be mailed to policyholders at least 30 days before the date
of the meeting. The notice
must give the date, time and place of the vote and must be accompanied
by a copy of the plan and other explanatory information about the
demutualization.
The New York
law provides each policyholder with one vote, which he or she may
cast in person, by mail or by revocable proxy.
The voting must take place at the company=s
home office, and the law even regulates the polling hours--between
10 a.m. and 4 p.m. For the
plan to be approved, two-thirds of all votes cast must be affirmative.
LIMITS
ON SUITS
The New York
statute protects the company against various malcontents by limiting
the period during which suit may be brought against the company with
regard to the validity of the demutualization or acts taken on its
behalf. Generally, all such suits must be brought within one year after
a copy of the approved plan is filed with the superintendent or six
months from the effective date of the reorganization, whichever is
later. This is a compelling reason to expedite the
transaction. (The New York
legislature passed an amendment to the law this year, primarily for
the benefit of Equitable, which requires that any aggrieved person
petition for judicial review within 30 days after the superintendent
approves the plan of demutualization.
This provision expires January 1, 1993.)
At
the hearing, the insurer must prove to the superintendent that the
demutualization is fair and equitable to the policyholders and that
there are sound reasons for the conversion.
In addition, it must show that the reorganization is in the
interest of the company and its policyholders and is not detrimental
to the public.
Obviously,
preparation is the key to success at the hearing. Once counsel and the superintendent=s
office decide on the hearing agenda, it is up to the company to present
its case. Its most senior
officers and independent auditors should testify as to the corporate
purpose and the financial effects of the conversion, respectively. Its actuaries should discuss the effect of the demutualization on
its business, and its investment bankers should describe its market
valuation.
The
state may present its own experts (for which the company will be obliged
to pay). These experts, generally
an industry consultant, an investment banker and an actuary, will
prepare reports on the demutualization for the superintendent.
It is important for the company to know the results of those
reports prior to the hearing so it will be in a position to rebut
adverse findings.
WEIGHING
THE DECISION
Within
60 days after the hearing, the New York superintendent must approve
or disapprove the plan. The
decision will be based on several factors, including whether the plan
complies with the state law and regulation for demutualization and
whether it is fair and equitable to policyholders and is not detrimental
to the public. Another factor is whether the new stock company will have capital
and surplus that is sufficient for its future solvency.
If
the plan is denied, the company is entitled to a hearing before the
superintendent within 30 days of the denial.
The company also should make certain that no superintendent
in another state believes that he or she has the right to approve
or disapprove the plan.
Another
condition, although not a procedural one, is that the company receive
a private letter ruling from the Internal Revenue Service, or an opinion
of tax counsel, that the demutualization will receive favorable tax
treatment. The IRS has ruled in the past that the conversion
of a mutual insurer into a stock insurance company constitutes a tax-free
recapitalization under section 368 of the Internal Revenue Code.
Section
five of the plan should discuss the crux of the deal--what is fair
and equitable to the policyholders.
In New York, policyholders=
rights in the company, which include the right to vote and to receive
some residual value upon the liquidation of the company, may be exchanged
for consideration represented by one or more of the following, depending
on the section of the law under consideration.
!
The policyholder's equity. To determine equity, the amount of a company's assets accumulated
from the operations of participating policies and contracts in force
on the effective date of the demutualization is divided by the sum
of the amount of assets allocated to the closed block of participating
business. To this figure are added the statutory reserves
and other statutory liabilities attributable to any group participating
policies and contracts in force on the effective date and not included
in the closed block of participating
business. The result of this
calculation represents the "going concern" value of the
insurer. These amounts are
subject to adjustment over the prior seven years at the discretion
of the superintendent.
!
Nontransferable, preemptive subscription rights
to purchase all the shares of the new stock company.
!
Ten percent of the net proceeds of the initial
public offering of the stock company's shares.
!
The establishment of a policyholder preference
account. The PPA is equal
to the excess of the amount of the insurer's total admitted assets
divided by the sum of the total amount of assets allocated to the
closed block of participating business, plus the policyholders' equity
and statutory reserves and liabilities attributed to policies and
contracts not included in the closed block of participating business.
The function of the PPA is solely to establish a priority of payment on liquidation, and its existence is not intended to restrict the use of application of the surplus of the stock company. The one exception is that the company cannot declare a cash dividend or repurchase its shares if the result of that expenditure would cause the amount of "net preference assets" to be less than the amount of the PPA. The PPA must be reflected in a footnote to the surplus of the reorganized insurer's statutory filings.
Policyholder
consideration may be paid to policyholders based on the estimated
proportionate contribution of each class of participating policies
and contracts to the aggregate payment being made to all policyholders. This allocation must also be Afair
and equitable,@
and the method by which it is determined should be spelled out in
the plan of demutualization.
Policyholders
who are entitled to vote on the plan and receive consideration are
those whose policies or contracts are in force on the date of the
adoption of the plan by the board of directors.
Payment of the consideration is determined for each policyholder
to the extent of his or her interest in policies or contracts in force
on the date of the adoption that remain in force on the effective
date of the demutualization.
A
CLOSED BLOCK
Section
six usually clears up some of the equations discussed in section five
by incorporating into the plan the portion of the New York law that
permits the new stock insurer to operate some, all or none of its
participating business as a closed block of participating business
for the exclusive benefit of the policies and contracts included in
the block. At the effective
date of the demutualization, the insurer must allocate to the closed
block sufficient assets, together with anticipated revenue, to provide
for the payment of claims, expenses and taxes and current payable
dividend scales. None of the
allocated assets may Arevert
to the benefit of the stockholders of the reorganized insurer.@
The New York statute contemplates a public stock offering by the insurer within two years of the demutualization. This is to ensure liquidity for the policyholder=s new equity interest. Like Equitable, many companies will decide to offer stock to the public when they convert. Public stock offerings are highly complex transactions which, unless exempted, must be registered with the Securities and Exchange Commission and qualified or registered in each jurisdiction where the company has policyholders or where it intends to sell shares.
The
price of shares in the subscription offering will be the same as the
price of any shares sold in the public offering.
And, in New York, the aggregate price from the sale of all
shares of the company to be offered in the demutualization must equal
the estimated value of the company in the public market.
Generally, this is determined by an independent appraisal of
the company conducted by an experienced investment banking firm.
If
any shares in the subscription offering are not purchased by policyholders,
the company may offer them to the general public.
The company should ensure that the shares are numerous enough
to be offered publicly since a portion of the proceeds must be paid
to policyholders. This offering can be localized in a community
offering or be broad-based in a regional or national public offering.
Public offerings generally are underwritten by investment bankers
on a Afirm
commitment@
basis for which the underwriter receives a discount of between 5%
and 10% of the public sales price.
A
firm-commitment underwriting means that the banker will buy all shares
offered (and possibly an overallotment amount if demand is great)
and resell them at the full public offering price to its retail customers. The company will rely on its investment adviser
to determine the timing and pricing of the public offering. If a discrepancy exists between the subscription
offering price and the price to the public, adjustments may have to
be made to the subscription offering price.
A
MATTER OF INCENTIVE
In
connection with the stock offering, company management should consider
implementing stock-related incentive plans at the time the insurer
is demutualized. Such plans
may become valuable through market appreciation or at the eventual
sale of the company. The plans may include these elements:
!
Incentive and nonqualified stock options. Options are granted to officers to be exercised
at a later date, generally at the subscription price, and not less
than the fair market value on the date of grant.
!
Stock appreciation rights. These plans offer the right to be paid cash for the difference between
the market price of the stock on the date of the SAR grant and the
price on the date of exercise.
!
Management development and recognition plans. These plans grant stock, independently of performance
objectives, to management. The
stock is payable over a period of years.
!
Bonus plans.
Shares of stock are paid to management based on predetermined
performance criteria, such as the company=s
after-tax profits or return on investment.
Several other executive compensation plans may also be put into place at or before demutualization.
Section
eight of the plan should outline the method of the implementation
of the plan and the effect of the demutualization on the company and
its business. To implement the plan under New York law, the
insurer must fulfill several requirements.
It must adopt articles of incorporation providing for stock
capitalization, delete the word mutual
in the company=s
name and adopt stock bylaws. It
also is required to file necessary documents with the superintendent
after policyholders and superintendent approve the conversion. (The filing also starts the clock on the statute
of limitations for filing suit to overturn the plan.) In addition, the insurer must determine the
effective date of the reorganization, which is the date the demutualization
is complete.
The
demutualization has no effect on the company=s
corporate existence; the new stock company is considered a continuation
of the former mutual insurer, and all assets and liabilities of the
mutual automatically transfer to the stock company with the recitation
of the magic words Aby operation of law.@ Likewise, the demutualization has no effect on litigation in which
the company may be involved--it merely carries over to the new stock
company. The company thereafter
will be governed by the laws applicable to stock companies.
After
the effective date of the conversion, policyholders no longer have
voting or liquidation rights, unless they own stock or are participating
in the PPA, and their rights are determined only in accordance with
their policies or contracts. Similarly,
unless the plan provides otherwise, all directors and officers of
the mutual will continue to serve in their respective positions until
new directors and officers are duly elected and qualified in accordance
with the new charter.
10-YEAR
PLAN
To
file the plan in New York, the insurer also must provide the superintendent
with a 10-year business plan and a statement regarding the issuance
of any nonparticipating business.
The insurer should treat this business plan confidentially
and not include it in the plan that will go to policyholders.
The
next section of the plan can provide the company with a bail-out option,
allowing it to amend or terminate the plan anytime before it becomes
effective. In New York, any
such changes in the plan must be approved by a majority of the board
of directors. However, if the insurer makes material amendments
to the plan which adversely affect policyholders after they have voted
to approve it or after the hearing is held, a new hearing or vote,
or both, may be necessary.
A
major concern of all mutual company managements is the vulnerability
of a public stock company to a takeover. While it is possible to remove
management, several factors make that unlikely.
This is especially true in New York, where stringent anti-takeover
law prohibits any person from offering to acquire, or acquiring, the
beneficial ownership of 5% or more of the voting stock of the converted
company for five years after the demutualization without the prior
approval of the superintendent.
If
this prohibition is violated, all acquired voting stock in excess
of 5% will be Asterilized,@ that is, not counted in any
vote, and the acquisitions may be enjoined by the company, the superintendent,
any policyholder or any stockholder. UNUM wrote a similar provision into its plan of conversion. The acquisition threshold was 10% and the prohibition
period three years. State
holding-company statutes also provide a certain degree of protection
from quick hostile takeovers.
Nonetheless,
the company should take steps, when it is demutualized, to protect
against hostile suitors. In
addition, it should make sure that the stock company=s
articles of incorporation and bylaws provide for staggered terms for
the directors so that only one-third of the board is up for election
each year, and for the removal of a director by stockholders only
for cause and only by a supermajority vote of stockholders.
In addition, the bylaws should make it possible for stockholders
to call a special meeting for removing directors or voting on the
change of control of the company only by a vote of a supermajority
percentage of shares outstanding. The company=s
governing documents also should include Afair
price@ provisions
for payment of all stockholders if an offer is made to purchase the
company and allow for sufficient authorized shares to be used as a
defensive measure. Over and above, however, the insurer=s best defense against a takeover
is to know its stockholders and their expectations.
Once broken down into its component parts, a demutualization is not mysterious. And it has a lot to offer all parties. To begin with, policyholders obtain a windfall; their equity in the company is unlocked and paid out in cash or stock. Also, the company is able to attract new and additional capital, management gets the chance to participate economically in the company=s growth and profitability, and the public is better able to gauge the vitality of the company by gaining access to GAAP financial statements. While the demutualization process requires investing a significant amount of time and money, policyholders and the public generally find that to do so is mutually advantageous.
