The plan of demutualization is probably the most important document in thedemutualization process.  More than a road map to the deal it allows the insurer to structure the future of the firm.

The much-anticipated demutualization of the Equitable Life Assurance Society of the United States is upon us.  In early May, 92% of 888,964 Equitable policyholders who cast ballots (approximately 2.2 million were eligible to vote) affirmed the insurer=s conversion to stock ownership for what is probably the largest mutual-to-stock corporate conversion to occur in the United States, if not in the world.  The Equitable intends to raise from $500 million to $700 million in a worldwide public offering in which the Axa Group of France will end up owning more than 49% of the equity shares based on its prior $1.0 billion capital infusion.

Other companies now are seriously considering converting to stock form.  And why not? The market for initial public offerings has not been this receptive for years.  The Equitable=s reason for demutualizing, stated in Article II of its plan of reorganization, is simple and may be a rationale shared by all mutual companies:  ATo enable the Company to obtain equity capital from sources that are unavailable to it as a mutual insurer, thereby strengthening its ability to meet all contractual obligations to policyholders and positioning the Company for long-term growth.@

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.

The final procedural step is the public hearing, the forum in which the superintendent gathers evidence to make a determination as to whether to approve the plan.  All eligible policyholders must be given at least 30 days prior notice of the hearing; newspaper notice also is required.  This permits all who are interested to attend the hearing and express their opinion about the demutualization plan.

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.

The consideration which the insurer must distribute may take a variety of forms.  It may be cash, securities of the stock company or another Ainstitution,@ such as a holding company for the insurer, and/or a certificate of contribution, repayable in five years with annual interest payable at the publicized monthly average. Other possibilities are additional life insurance or annuity benefits, increased policy dividends, other consideration or any combination of these forms.

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.

Section seven of the plan should speak to the distribution of the stock company=s capital stock.  The first part of the section will describe how shares will be distributed to policyholders in what is called a subscription offering.  The subscription offering is the part of the deal that allows policyholders to exercise the nontransferable subscription rights they receive as part of their consideration.  The company can require policyholders to pay for the purchase of these shares with cash or by using a portion of the policyholder equity to be paid to them in the conversion.  Many of the model acts contemplate the use of policyholder equity to buy the insurer=s shares.  This section outlines policyholder purchase priorities and how directors, officers and employees of the company may purchase shares in the subscription offering.

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.