Investors cash in on demutualisation fever

Demutualisations, the change of a company's status from a mutual body owned by its customers to a limited company owned by shareholders, are becoming an increasingly common event in British commercial law. These transactions are important because they impact on a vast number of people who have become members of these institutions over the years.

The two groups most in the public eye in this respect are the mutual life assurance companies and the building societies, including the Norwich Union and Halifax, whose roots are in the small local savings institutions established in the 19th century to promote thrift. They were, in essence, clubs in which the members pooled their savings for collective investment so as to receive a benefit on the occurrence of certain events.

Typically, in the case of life assurance that event was death. In the case of building societies it was the purchase or building (hence the name) of a home which would result in part of the members' accumulated savings being lent back to them. Over the years, many of these life assurance companies and building societies extended their operations, building up reserves to support the on-going business.

The pressures of the late 20th century have caused them to review their constitutions. They are having to face up to increased regulation, particularly in the light of the Financial Services Act 1986, increased expenses in the sale of their products and growing competition. And a number of mutual life assurance companies are becoming concerned with their solvency margins for regulatory purposes.

All these companies provide services principally to large numbers of retail investors, so they are heavily regulated and the change to limited company is not always straightforward. The members' interests need to be adequately protected and statutory procedures have to be followed if demutualisation is to be effective.

The demutualisation of building societies is regulated by Sections 97 to 102 of the Building Societies Act 1986 and can take place in one of two ways: either by the transfer of the business to a specially formed company (usually called "conversion") or by the transfer of the business to an existing company (most commonly called a take-over). In both cases the society proposing to demutualise has to send to investing and borrowing members a document containing the information required by Schedule 17 of the Building Societies Act 1986 and the Building Societies (Transfer of Business) Regulations 1988. The investing and borrowing members have to vote on the proposal which then has to be confirmed by the Building Societies Commission. If it is confirmed, the vesting of the business in the successor company can take place.

The business of a building society is a valuable asset and the people with the best claim to a share in the value are the current members. The best known problems with conversion or takeover lie in the provisions of Section 100 of the Building Societies Act, which sets out what can and cannot be given by way of benefits to members. There have been three cases on the section - Abbey National Building

Society v Building Society Commission, Cheltenham & Gloucester Building Society v Building Society Commission and Building Society Commission v Halifax Building Society - which established the limits.

The benefits appear to be limited to cash from the successor company, the society or shares from the successor. Investing members of less than two years standing and borrowing members cannot receive cash but are able to receive shares. In the latter case care must be taken to avoid breaching the "priority" rule.

Care is also required in the drafting of benefits schemes. Section 100 continues to give rise to problems and is generally recognised to be badly drafted. Notwithstanding, the recently published consultation paper and draft bill to amend the Building Societies Act 1986 does not propose to make any alterations so the difficulties are likely to continue.

The distinction also needs to be made between takeovers and conversions. Although in both cases the borrowing members need only vote in favour by a simple majority, a higher threshold is required for investing members to approve take-over by an existing company - 75 per cent of members representing 50 per cent of the votes or 90 per cent of the balance - compared with a conversion to a specially formed company - 75 per cent majority with a voting requirement of 20 per cent of voting members.

A specially formed company needs protective provisions for the first five years of its life to prevent any person holding 15 per cent or more of its shares or debentures. It is also subject to the priority liquidation distribution right which gives former members of the transferring society the right to share in the assets of the successor company if it is wound up. These last two points give rise to practical issues in conversion.

The change in status of a mutual life assurance company to a proprietary company is not without its complexities but does not give rise to such high-profile issues. The problems of giving the value of a life assurance company to its members do not usually loom so large since direct payments to policy-holders are unusual and there is no equivalent of section 100 of the Building Societies Act. Policy-holder support for the transfer now involves the purchaser buying the business of the life company by paying an amount into the life fund for paying special bonuses or increasing the bonuses payable to the holders of the with-profits policies. In exchange, the purchaser acquires all or part of the non-profits business (such as the unit-linked business) and a participation (say 10 per cent) in the with-profits fund.

As with building societies, the procedure for transfer under Schedule 2C of the Insurance Companies Act 1982 is designed to give protection to the investors. The company must prepare a scheme setting out the terms of the transfer and there must be a report on its terms by an independent actuary. Details of the scheme and report are circulated to policy-holders who can object to the scheme in court.

In theory, once the scheme has been approved, the business of the company is transferred and the old company can be wound up. In practice, life is not so simple. The statutory scheme may not be an effective way of transferring the policies of overseas policy-holders or overseas assets.

Lawyers will become familiar with the pitfalls as more demutualisations take place.