Fiduciary Obligations & Mutual Holding Companies

More heat than light has been directed to the subject of demutualizations and mutual holding companies. Perhaps three simple statements will help clear the air.

• A mutual holding company is only a form of doing business and not a conversion of equity interests.

• The board of directors of a mutual insurer or a mutual holding company generally has fiduciary obligations to policyholders just as the board of directors of a stock insurer has fiduciary obligations to its stockholders.

• The board of a mutual is subject to standards similar to those of the board of a stock insurer in reacting to unsolicited offers to acquire the company.

Nature of a Mutual Holding Company

The creation of a mutual holding company changes the form under which a mutual insurer does business, but does not affect the equity interests of any policyholder. Opponents of demutualizations have succeeded in sowing confusion by arguing that the policyholder should get something in the process. The policyholder does get something - the same equity interest owned in the insurer is converted to an equity interest in the insurer's parent holding company, the mutual holding company or MHC.

If this is true, why all the fuss? Stock insurers say a mutual holding company should have a shelf life of two years and then should be required to convert into stock holding company. Why? If the fundamental change that occurs in the formation of a MHC is a change in form of doing business - why is that a problem for the stocks?

By the way, I agree that the MHC is only a transition vehicle, but I reach that conclusion because it is a clumsy and lengthy form through which to do business. The friction between the interests of the downstream stockholders, if stock is issued, and the policyholders' interests as owners of the holding company likely will result in a conversion of the holding company into a stock company, but I do not agree that legislation to that effect should be introduced.

Fiduciary Obligations of a Mutual or MHC Board

While the law likely will be refined over the next several years as litigation is brought to clarify the rights of policyholders and the duties of mutual or MHC board members, most lawyers I speak with agree that such boards have duties at least as stringent as stock company boards. An argument can be made that mutual or MHC board members have to protect the equity interest of their policyholders and shareholders as well as the insurance obligations of their policyholders.

This fiduciary obligation is especially pronounced where the mutual holding company board approves the issuance of shares of its downstream company. In a perfect world, if the fair market value of an MHC is $100 million and the Board authorizes the issuance of shares representing 50 percent of the equity of the MHC, new shareholders should pay $100 million for their shares and receive shares representing an equity interest of 50 percent of the total enterprise. Therefore, the MHC equity owners (the policyholders) own 100 percent of the MHC having a fair market value of $100 million prior to the downstream issuance of stock and own 50 percent of the MHC having a fair market value of $200 million after the issuance of stock. Their interest is not diluted. Even very bright people have trouble with this concept. In a May 21 New York Times article entitled, "Mutual Insurers May Be Igniting a War Between Shareholders and Policyholders," the authors comment about such a stock issue by saying, "Yet, policyholders aren't directly compensated for the diminution of voting stakes, except sometimes with stock-subscription rights". But what about the $100 million contributed to the MHC for shares?

We all know that supply and demand, market value of the shares and costs of a public or private offering may vary these values, but the board is obligated to value the offering on a fair basis taking into consideration these factors. If insiders are involved as shareholders, the duty of care is elevated.

There is a real temptation to legislate the specifics of these fiduciary obligations. For example, in the second draft of the "white paper" being prepared by the Mutual Holding Company Working Group of the NAIC, there are suggestions of limiting the types of stock which can be issued by the MHC subsidiaries, limiting the possible dilution of policyholder equity ownership and providing for the structure of boards of directors. In my view, such proposals limit flexibility, which might well be in the interest of policyholders, while providing governing boards "safe harbors" which might cover abuses. Let case law on fiduciary duties evolve.

Mutual or MHC Responses to Unsolicited Offers

In responding to an unsolicited offer for control, the directors of a corporation (including a mutual corporation) are generally afforded the protection of the business judgment rule, in which courts do not second guess directors where actions are taken in good faith by informed, disinterested directors. In other words, a board can "just say no" to an unsolicited offer of cash or stock payable to policyholders for their equity interest in the mutual company absent other circumstances requiring the board to consider such an offer.

The protection of the business judgment rule does not apply when a company is put "in play." In the mutual context, the clearest example is where a board causes a mutual company to demutualize by selling control to a third party, the so called sponsored demutualization. The responsibility of the board in this context is to maximize current value for the Company's policyholders.

An interesting contest currently is unfolding involving just these issues. Mercer Mutual Insurance Company recently announced a demutualization under Pennsylvania's "thrift style" approach, following in the footsteps of Old Guard. In a "thrift style" demutualization, policyholders are first given the right to purchase shares in the demutualized company, followed by officers, directors, employees, vendors and, finally, the public. The Mercer offering is valued at $25 million.

Question: is this action putting the company "in play"? There are arguments both ways, but the answer is probably not.

A policyholder of Mercer, Franklin Mutual Insurance Company, made an unsolicited offer to the board of Mercer. The offer is to pay policyholders $23.2 million cash for their interest and to contribute an addition $5 million as capital to Mercer. Mercer's board says, "No; we want to stay independent". A fight is underway for the policyholder's list.

Can the Mercer board "just say no"? Are they protected by the business judgment rule or have they put the company "in play" and are now required to maximize near term value for the policyholders? Stay tuned.

Conclusion

There are well developed laws, both statutory and case law, which protect the equity interests of policyholders in the same way that shareholders in stock companies are protected. Creating different laws for mutual companies and mutual holding companies may actually limit the benefits of applicable existing laws.