Frederick J. Pomerantz examines mutual holding company laws in the US and forecasts stormy weather in New York, which has proposed legislation pending.

Mutual insurance holding company laws permit a mutual insurance company to partially demutualise by reorganising as a mutual holding company that owns a stock insurance company subsidiary, either directly or indirectly through an intermediate stock holding company. Iowa was the first state to exact a mutual holding company reorganisation statute in July 1995. Since then, 15 other states (California, Florida, Kansas, Louisiana, Maryland, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, Texas and Vermont) and the District of Columbia have enacted mutual holding company enabling legislation, either as a separate act or as part of a broader scheme of legislation affecting demutualisation and other insurance company restructuring. Proposed legislation is pending in Illinois, Indiana, Louisiana, Massachusetts, Mississippi, New York, South Carolina and Wisconsin. In all but two jurisdictions, mutual holding company statutes apply to all mutual insurance companies. In New York, the proposed legislation would apply only to mutual life insurers.

The first mutual holding company law was enacted by the Iowa legislature with little organised opposition. Some of the other recent legislation introduced, in particular, in New York and Massachusetts, have galvanised the opposition from certain segments of the insurance industry itself.

Public hearings on the proposed New York statute were held on 8 October 1997 before the New York State Assembly Standing Committee on Insurance. Among those testifying in opposition to the New York Statute were consumer advocates Ralph Nader and Jason Adkins of the Center for Insurance Research, but also included New York State's Lieutenant Governor, Betsy McCaughey Ross.

Among the basis for opposition cited by opponents to the New York statute are the suggestions that under the bill, there are no standards or provisions to ensure that the management of the new mutual holding company will be accountable to its current policyholders, or that any meaningful checks and balances will exist. It is also alleged that the full value of the policyholder surplus of the mutual insurance company should be expressly recognised as belonging to policyholders. The bill provides for subscription rights but not for the distribution of the surplus to policyholders in the form of stock, cash of other valuable consideration. This criticism, of course, assumes that policyholders are truly the equity owners of the mutual insurance company, a claim that has been refuted by supporters of the bill who point out that insurance policies are not "securities" like corporate stock. If an insurance policy lapses or terminates, the policyholder gets only the cash surrender value (if any) and has nothing to sell or transfer or bequeath in the event of death. If a life insurance policyholder dies, the policyholder is entitled only to the death benefits provided for in the insurance policy. Thus, the nature of the relationship between the company and its policyholder becomes an integral part of the debate over the New York bill.1

Recently, the National Association of Insurance Commissioners (NAIC) has been reviewing mutual holding company reorganisations and other alternative demutualisation methods. A draft white paper on the subject was circulated at the spring 1998 national meeting of NAIC which took place in Salt Lake City, Utah. Among the subjects being considered by the NAIC's Mutual Holding Company Working Group in its draft white paper are the following:

1. Justification of the mutual holding company option, specifically, whether the mutual holding company option is truly necessary or in the best interests of mutual insurance companies seeking access to the capital markets.

2. Treatment of policyholders under the mutual holding company structure, specifically, whether policyholders' interests are potentially diluted as a result of the mutual holding company reorganisation in the event that stock is issued to non-members, including executive management of the mutual holding company.

3. Process and procedures for mutual holding company transactions, specifically, since only a small minority of mutual insurance company policyholders traditionally exercise their voting rights, and since these are extraordinary transactions, whether there should be a relatively high standard for member approval of these transactions, and whether steps can be incorporated in the plan of reorganisation to facilitate increased participation by policyholders in approving these transactions.

4. Ongoing regulatory oversight, specifically, whether any aspects of the mutual holding company structure that require different or enhanced ongoing regulatory oversights.

5. Improvement of the traditional demutualisation process, specifically, whether improvements can be made to the traditional demutualisation laws without compromising policyholder interests.

Recently, opposition to the mutual holding company reorganisation structure has come from new sources, namely, state legislators and some forces inside the insurance industry.

For example, in the case of Mutual Life Insurance Company of New York, Prudential Life Insurance Company of America, Standard Insurance Company, Manufacturers Life Insurance Company and others, these companies have announced that they will be demutualised rather than wait for the enactment of mutual holding company legislation.2 Further, a coalition of large stock insurers is opposing mutual holding company reorganisations. Their stated reasons revolve around corporate governance issues but their real reasons appear to be competitive in nature.

Further, new demutualisation statutes in Pennsylvania and Illinois have given rise to a different approach to demutualisation. Under these laws, the mutual insurer is converted to a stock company and at the time of the conversion the stock company sells newly issued shares in a subscription rights offering. Under the subscription rights offering, policyholders of the mutual company are offered the first right to buy the shares of the converted company of the converted insurer.

Shares that are not subscribed by the policyholders can then be offered in a stand-by public offering. Consequently, the new laws do not require that the policyholders receive in the demutualisation the full surplus of the insurer in stock or cash or a combination of stock and cash. Such statutes help refute the position of consumer advocates that policyholders own the surplus, in favour of the idea that policyholders have certain intangible rights under the law.3

It has even been questioned whether the limits on the percentage of voting stock executives of a mutual holding company may own - between 5% to 18% over a number of years under the proposed New York law - may be pre-empted by Federal law.4 Specifically, under Section 7918(A) of the proposed New York law, after the effective date of the reorganisation, the mutual holding company must continue to hold, directly or through one or more stock holding companies, at least 51% of the issued and outstanding voting stock of the reorganised insurer. The reorganised insurer and any stock holding company may issue to the mutual holding company and to other persons securities, including voting stock, non-voting stock and securities convertible into voting or non-voting stock provided that, after giving effect to such issuance, in the aggregate the issued and outstanding voting stock of the reorganised insurer held, directly or through one or more stock holding companies, by the mutual holding company is not less than 51% of the issued and outstanding voting stock of the reorganised insurer.

Further, under Section 7918(C) of the proposed New York law, until six months after completion of either an initial offering or private equity placement, neither a stock holding company nor the reorganised insurer may award stock options or stock grants to officers or directors of the mutual holding company, the stock holding company or the reorganised insurer. And until two years after the reorganisation, the officers and directors of the mutual holding company, the stock holding company and the reorganised insurer may not own beneficially, in the aggregate, more than 5% of the voting stock of the stock holding company or the reorganised insurer.

Under Section 7918(E) of the proposed New York law, the officers and directors of the mutual holding company, the stock holding company or the reorganised insurer may not own beneficially, in the aggregate, more than 18% of the voting stock of the stock holding company or the reorganised insurer, and under Section 7918(F), outside directors of the mutual holding company, the stock holding company and the reorganised insurer may not own beneficially, in the aggregate, more than 3% of the voting stock of the stock holding company or the reorganised insurer.

Finally, under Section 7918(G) of the proposed New York law, in no event may any person acquire beneficial ownership of more than 15% of any class of voting securities of the reorganised insurer, any stock holding company or any other institution which owns, directly or indirectly, a majority of all of the voting securities of the reorganised insurer, without prior approval of the Superintendent.

According to certain consumer advocates, any or all of the foregoing restrictions on stock issuance to directors and officers may violate the Capital Market Efficiency Act which is part of the National Securities Markets Improvements Act of 1996 (the Act), which pre-empts state laws and regulations regarding certain types of securities and transactions, provides the SEC with broad authority to exempt any persons, securities, or transactions from securities regulations, and requires the SEC to consider efficiency, competition, and capital formation in connection with rule making.5 The Act was enacted in part to deal with conflicts between the Federal securities laws and the 50-sets of state securities laws (blue sky laws) that require offerings to comply with certain substantive standards, known as merit requirements. If the offerings fail to meet those standards, the securities cannot be sold in the particular state, even if the offerings comply with the Federal securities regulatory scheme requiring full disclosure of all material facts.

In its draft White Paper on Mutual Insurance Holding Company Reorganisations, the Mutual Holding Company Working Group specifically noted that on 25 July 1997 the SEC Division of Corporation Finance issued Staff Legal Bulletin No. 3 concerning the National Securities Market Improvement Act of 1996. The Act and the bulletin provide that state laws authorising fairness hearings concerning the registration of certain securities are pre-empted. Securities offered by the mutual holding company system are likely to be covered by this federal statute. According to the White Paper, the state law shall not directly or indirectly prohibit, limit or impose conditions on the use of any offering document, or various other documents except when required by the state of domicile, nor shall the state directly or indirectly prohibit, limit or impose conditions upon the offer or sale of such security. It is not clear how this pre-emption will impact state regulatory efforts to oversee stock offerings of the mutual holding companies.

At the time that the Iowa mutual holding company reorganisation statute became law, the Act had not yet been legislated into existence. There is no evidence in the legislative history of the proposed New York law that legislators who drafted the version currently being considered looked into the ramifications of possible conflict between the New York legislation and the Act.

Questions have also been raised, in the course of hearings before the New York State Standing Assembly Committee on Insurance, whether Federal bankruptcy laws apply to the mutual holding companies themselves thereby potentially jeopardising New York State's exclusive regulatory jurisdiction over mutual insurance companies, which it has heretofore had under the McCarran-Ferguson Act. Because the mutual holding company is not an insurance company per se, the question has been raised to whom will millions of New York policyholders with mutual insurance companies turn to secure their rights, benefits, and protections in the event of the transfer of their interests from the mutual insurance companies to the mutual holding companies.

In its White Paper, the Mutual Holding Company Working Group states:

Typically, state MIHC statutes contain "reach-up" provisions intended to make the assets of the MIHC available to protect policyholders in the case of an insolvency of the converted stock insurance company. Federal bankruptcy laws, however, could be used to defeat the reach-up provisions. Stockholders or creditors of an intermediate stock holding company could seek protection under the jurisdiction of a federal bankruptcy court to prevent the Commissioner's sale of assets to meet the needs of the policyholders. If the bankruptcy court were used to liquidate the intermediate holding company, the assets would be distributed in accordance with the priorities of the federal bankruptcy code, which favours creditors, rather than according to the state insurance code priorities favouring policyholders. In federal bankruptcy, the MIHC, as a stockholder, would only hold rights to any assets of the intermediate company that remained after all of the obligations of the bankruptcy estate were satisfied.

Insolvency at the MIHC level could also be problematic, despite statutory provisions calling for liquidation of the MIHC in accordance with the state insurance laws. The MIHC would be subject to federal bankruptcy proceedings unless it fell into a category of entities specifically exempted from the federal code, in this case, the exemption for a domestic insurance company. According to case law, the state would have to show not only that the MIHC is classified as an insurance company for liquidation purposes under state law, but also that the MIHC is "equivalent" to an entity, specifically a domestic insurance company, which is exempted from the bankruptcy code. To determine whether an entity is equivalent to a domestic insurance company, federal courts will consider: (1) the "essential attribute" of the company, (2) the degree of state regulation of the entity involved, (3) the existence of a statutory scheme for liquidation or rehabilitation; and (4) the public or quasi-public nature of the business.

These and many other questions are raised by New York's proposed mutual holding company legislation despite the fact that the bill contains arguably the most extensive corporate governance standards of any mutual holding company conversion statute heretofore adopted or currently being considered by state legislators across the nation.

Where this will all shake out in the politically charged atmosphere of a gubernatorial election year in New York - with New York's Lieutenant Governor seeking the nomination of the Democratic Party in opposition to her boss, the incumbent Republican Governor, and with powerful forces in the Democratic-dominated New York State Assembly and a coalition of some large stock insurers aligned with consumer forces against the proponents of the bill led by the Republican-dominated New York State Senate, the Superintendent of Insurance, and most of the insurance industry - is not known at this time. Further, plaintiff class action lawyers are licking their chops waiting for an opportunity to bring expensive litigation against companies which have undergone such reorganisations at the first available moment and the ceos of some major insurance companies are questioning the continued relevance of the NAIC and of state regulation in the coming financial services universe. It is undisputed that it is difficult to pick up a newspaper today without encountering yet another story about an insurer merging with another insurer, a United States financial services company or insurance conglomerate acquiring another United States financial services company or insurance conglomerate or even combining with a foreign insurance company, or a non-United States financial services company or insurance conglomerate acquiring a Unites States life insurer of mutual fund company. At the same time, there is continuing time pressure for Congressional enactment of a major financial services overhaul, enabling banks to purchase insurers or affiliate with them in new ways. The financial services revolution is here in earnest.

Frederick J. Pomerantz is a partner of Wilson, Elser, Moskowitz, Edelman & Dicker, based in the New York City office.

1. The Securities and Exchange Commission has, in several no action letters, recognised that membership interests in mutual insurance holding companies do not constitute securities. eg. Acacia Mutual Life Insurance Company (27 June 1997); American Mutual Life Insurance Company (13 June 1996); General American Life Insurance Company (20 February 1997); and Pacific Mutual Life Insurance Company (17 April 1997). Much of the surplus of a mutual life insurance company that is built up is attributable to premiums paid over decades by former and deceased policyholders. Thus, it is questionable whether policyholders of a mutual life insurance company own a piece of the policyholders surplus, notwithstanding the requirements of statutes relating to full demutualisation.

2. This willingness of two of the largest mutual life insurance companies in the US to use traditional demutualisation techniques casts doubt in the minds of opponents of MHC legislation as to the credibility of claims of proponents as to the lack of availability of practical means under current law of accessing available capital to fund long-term growth.

3. In the one subscription rights conversion completed to date, Old Guard Insurance Company, under Pennsylvania law, all of the stock was oversubscribed by the policyholders.

4. For example, the National Securities Markets Improvements Act of 1996 (Public Law 104-290 [H.R. 3005]) holds that no law, rule, regulation or order . . . of any State . . . shall directly or indirectly prohibit, limit, or impose conditions based on the merits of any covered security. Covered securities include securities listed on the New York and American Stock Exchanges or listed on the National Market System of the Nasdaq Stock Market. 15 U.S.C. 77r.

5. The joint congressional committee charged with the responsibility to resolve differences in the house and Senate versions of the Act characterised the situation prior to the Act as involving a "dual system of regulation that, in many instances, is redundant, costly, and ineffective." H.R. Conf. Rep. No. 104-864, at 39(1996). The Committee stated its intent for the Act to "eliminate duplicative and unnecessary regulatory burdens while preserving important investor protection by re-allocating responsibility over the regulations of the nation's securities markets in a more logical fashion. . . ." Id at 39-40.