“A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior…the level of conduct for fiduciaries [has] been kept at a level higher than that trodden by the crowd.” — Benjamin Cardozo2 Introduction Following the onset of the financial crisis in 2008 and the resulting volatility in the stock prices of many publicly traded insurance companies, many mutual insurance companies began touting their mutuality as a selling point to potential policyholders. Some mutual companies went so far as to center national marketing campaigns on the virtues of the mutual form, citing the absence of a shareholder constituency as an advantage permitting these companies and their managements to put the interests of their policyholder-members first. Implicit in this concept is the notion that directors of a stock insurance company owe fiduciary duties first to their shareholders and must oversee the company in furtherance of those duties, while directors of a mutual company owe their first and only duty to the policyholder-members. While this sounds simple in a television commercial, when policyholder-members have contractual rights in their capacity as policyholders and other rights in their capacity as members granted by statute and a company’s organizational documents, questions arise as to how the duties owed by mutual directors differ from those owed by stock company directors and whether such duties are owed to policyholdermembers in their capacity as policyholders, members or both. The answers to these questions can have a significant impact on how the directors of a mutual insurance company exercise their duties. The situations in which mutual company board members must take into account their fiduciary duties are many, but certain types of decisions warrant particular focus. Specifically, certain decisions should require special care and attention, including transactions in which the company will (i) merge or otherwise combine with another company, (ii) affiliate with another company, (iii) demutualize or reorganize itself into a mutual holding company or otherwise engage in a fundamental organizational restructuring, (iv) liquidate all or a material part of its operations, (v) enter into a transaction that involves a fundamental change in business operations (including a material acquisition, disposition, reinsurance arrangement or joint venture), or (vi) make a material change in the rights of policyholder-members. Mutual company boards should be briefed on their fiduciary duties prior to commencing deliberations on any of these matters, and should understand fully how their duties are discharged in these contexts. The framework for this decision-making is the subject of this article. There is a wealth of legal authority and commentary from academics and practitioners addressing the duties that the directors of a stock company owe to shareholders in the context of a proposed business combination and certain other significant transactions. However, the same cannot be said of the duties that the directors (or trustees) of mutual insurance companies and mutual insurance holding companies3 owe in similar circumstances. The relative lack of legal authority and commentary can be attributed, at least in part, to the facts that: (i) the statutes and case law governing the corporate form and director duties for mutual insurers are typically much less well developed than those governing stock companies;4 (ii) transformative transactions 1 The authors thank Greg Oguss and Brian W. Tobin for their significant contributions to this article. 2 Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928). 3 Generally, when used herein, “mutual” and “mutual insurer” refer to both mutual insurance companies and mutual insurance holding companies. 4 A preponderance of stock companies are organized in Delaware. Delaware has an extremely well-developed and well-tended-to body of corporate law, which exists as a result of legislative initiatives, an active corporate law bar, and a high-quality judiciary that addresses key issues “ 2 An Honor Most Sensitive: Duties of Mutual Company Directors This lack of guidance has frustrated board members of mutual insurers and their advisors seeking to understand and satisfy their duties in the context of business combinations and other significant strategic transactions. The problem has become particularly acute as the pace of consolidation, reorganization and strategic transactions among mutual insurers has increased in recent years. As a general matter, the fiduciary duties owed by stock company directors may vary from one state to another. While not controlling in other states, Delaware law often guides the decisions of courts in other jurisdictions on matters of corporate law and governance… Under Delaware case law, fiduciary duties of corporate directors are usually described in three categories: the duties of care, loyalty and candor. involving mutual insurers have occurred much less frequently than similar transactions involving insurance and non-insurance related stock companies; and (iii) policyholdermembers historically have been less likely to bring suit against boards of directors for alleged misconduct than shareholders of stock companies. This lack of guidance has frustrated board members of mutual insurers and their advisers seeking to understand and satisfy their duties in the context of business combinations and other significant strategic transactions. The problem has become particularly acute as the pace of consolidation, reorganization and strategic transactions among mutual insurers has increased in recent years. 5 Further underscoring the importance of boards understanding and appropriately exercising their duties in the context of a significant transaction, the frequency of litigation following large-scale business combinations generally has increased sharply in recent years. 6 From 2005 to 2013, the annual percentage of stock company business combination transactions over $100 million challenged in shareholder litigation rose from 39% to 97.5%. 7 While litigation is less common in mutual company transactions, the overall increase in the level of litigiousness surrounding substantial business transactions is concerning and makes it crucial that members of boards of directors of mutual insurers understand the scope of the duties owed to members in the context of these transactions. 8 In this article, we will briefly review the fiduciary duties of stock company board members generally, which mutual boards should consider when evaluating proposed business combinations or other significant transactions. Next, we will consider whether, and to what extent, these duties apply to mutual insurers. Finally, we will conclude with a discussion of the so-called Revlon duties in a mutual company context, and whether such duties can or should be applied in the context of business combinations involving mutual companies. Summary of Fiduciary Duties Generally To understand the duties that the directors of a mutual company may owe to their policyholder-members, one must first have a basic understanding of the duties that directors of a stock company owe the company’s shareholders. As a general matter, the fiduciary duties owed by stock company directors may vary from one state to another. While not controlling in other states, Delaware law often guides the decisions of courts in other jurisdictions on matters of corporate law and governance; therefore, we will briefly summarize a director’s fiduciary duties under Delaware law. 9 Under Delaware case law, fiduciary duties of corporate directors are usually described in three categories: the duties of care, loyalty and candor. 10 These duties can be summarized as: ■ Duty of Care: The seminal Van Gorkom decision in 1985 stated a board’s duty of care as the duty to inform themselves, individually and collectively, fully and in a deliberate manner prior to voting on a third-party transaction as significant as a merger or sale of the company. 11 ■ Duty of Loyalty: A board’s duty of loyalty is a commitment by the fiduciary to act not in self-interest, but in the interest of the beneficiary of the fiduciary relationship, i.e., shareholders, in pursuing a proposed transaction. 12 5 We believe the trend towards consolidation among mutuals will continue as some mutual companies look to expand following a long period of great financial success, while others (particularly smaller or more niche-focused insurers) struggle with capital constraints, slow organic growth, high expense ratios, lack of diversification and issues involving succession planning. 6 See Jill Fitch et. al., Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform, 93 Tex. L. Rev. 557, 558–59 (2015). 7 Id. 8 See Section III infra for a discussion of certain recent litigation relating to material business transactions of mutual insurers. 9 See note 4. 10 While a detailed description is beyond the scope of this article, in-depth analyses of such duties in the context of business combinations have been offered in countless other sources. See, e.g., Holly J. Gregory, The Board’s Role in M&A Transactions, Practical Law The J., May 2014; Frank Easterbrook, Contract and Fiduciary Duty, 36 J.L. & Econ. 425 (1993); Robert Cooter, The Fiduciary Relationship: Its Economic Character and Legal Consequences, 66 N.Y.U. L. Rev. 1045 (1991). 11 Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985). Further elaborations of the duty of care have stated directors are required to take an active and direct role, from beginning to end, in a merger or sale and may not be passive instrumentalities during the transaction. See Citron v. Fairchild Camera and Instrument Corp., 569 A.2d 53, 66 (Del. 1989); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d, 946, 954 (Del. 1985). 12 See, e.g., Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993). Sidley Insurance & Reinsurance Law Report | 2016 3 ■ Duty of Candor: While not as universally adopted as the duties of care and loyalty, the Delaware Supreme Court has described the duty of candor as the board’s duty to “disclose fully and fairly all material facts within [the board’s] control that would have a significant effect” upon the shareholder’s vote. 13 Generally, a director is required to discharge his or her duties in good faith, which may be violated if the director intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. 14 Absent special circumstances, judicial scrutiny of a corporate board’s actions are typically governed by the business judgment rule, which “presumes that ‘in making a business decision, the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.’ ”15 As a general rule, this presumption shields a board from liability for alleged errors in business judgment, providing the directors with latitude, and incentivizing them, to take risks with the goal of maximizing shareholder value over the long-term. For example, in Shlensky v. Wrigley, Phil Wrigley’s refusal, as president and a director of the Chicago Cubs, to install lights at Wrigley Field to permit night games and raise additional revenue, even in the face of the team’s continuing financial losses, was determined to be a protected business decision in the absence of a “clear showing of dereliction of duty.”16 The rationale for the business judgment rule was cogently expressed in Dodge v. Ford Motor Co., in which the Court noted, “[J]udges are not business experts.”17 However, there are exceptions to the business judgment rule, which, if triggered, subject a board’s action to heightened judicial scrutiny. One such exception is when a company receives a hostile takeover bid, in which case, rather than applying the deferential standard of the business judgment rule, under Delaware law, a court will evaluate whether any defensive measures adopted by the board were reasonable in proportion to the nature of the perceived threat to shareholders’ interests posed by the hostile bid. 18 A second exception occurs in a transaction where one or more directors have a conflict of interest and that conflict is not cured in some way, such as an affirmative vote in favor of the transaction by a majority of disinterested directors. Because of the potential for self-dealing, if such a transaction is challenged, a board would bear the burden of justifying its actions under a demanding “entire fairness” standard of review. 19 A third situation in which the business judgment rule may not apply is in the face of certain business combination transactions where a board’s Revlon duties are triggered, subjecting the decision-making to enhanced scrutiny and generally requiring the board to get the best price reasonably available. 20 13 Stroud v. Grace, 606 A.3d 75, 85 (Del. 1992). 14 Lyondell Chemical Co. v. Ryan, 970 A.2d 235, 243 (Del. 2009) (discussing good faith in the context of alleged violation of the duties of care and loyalty). The duty of good faith is not thought to be a separate duty apart from the duties of care, loyalty and candor. See, e.g., Nagy v. Bistricer, 770 A.2d 43, 48, n.2 (Del. Ch. 2000) (dismissing an alleged breach of the ‘duty of good faith’ as a standalone claim by determining that “a director cannot simultaneously act in bad faith and loyally” but stating that “[i]f it is useful at all as an independent concept, the good faith iteration’s utility may rest in its constant reminder (1) that a fiduciary may act disloyally for a variety of reasons other than personal pecuniary interest; and (2) that, regardless of his motive, a director who consciously disregards his duties to the corporation and its stockholders may suffer a personal judgment for monetary damages for any harm he causes”). 15 In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 52 (Del. 2006) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)). 16 See Shlensky v. Wrigley, 237 N.E.2d 776 (Ill. App. 1968). 17 Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919). 18 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985). Elaborating on the Unocal test in a later decision, the Delaware Supreme Court held that, if the defensive measures are neither coercive of shareholders nor preclusive of a bid being made by the potential acquirer, such measures must simply fall within the “range of reasonableness” in proportion to the perceived threat. Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1387–88 (Del. 1995). 19 Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983). 20 The enhanced scrutiny of Revlon applies in three situations. First, during an active auction process when a company is seeking to sell itself or otherwise effect a break-up of the company. Paramount Commc’ns, Inc. v. Time Inc., 571 A.2d 1140, 1150 (Del. 1989). Second, when, in response to an offer, a company “abandons its long-term strategy and seeks an alternative transaction” that involves a break-up of the company. Id. Third, when there is a sale or change of control of the company. Paramount Commc’ns, Inc. v. QVC Network Inc., 637 A.2d 34, 43 (Del. 1994). In such situations, if the transaction involves cash or, in certain circumstances, mixed consideration (or, if the acquirer has a controlling shareholder, in a stock-for-stock sale), a board is thought to be in “Revlon mode,” which imposes special duties on corporate directors with respect to both the negotiation process and the outcome of the transaction. See In re Smurfit-Stone Container Corp. S’holder Lit., No. 6164-VCP, 2011 WL 2028076 (Del. Ch. May 24, 2011) (holding that Revlon applied in a transaction in which the acquirer’s stock represented approximately 50% of the consideration); but see In re Santa Fe Pacific Corp. S’holders Lit., 669 A.2d 59 (Del. 1995) (holding that Revlon did not apply in a transaction in which 33% of the consideration was in the form of cash). Revlon may also apply in a stock-for-stock sale 4 An Honor Most Sensitive: Duties of Mutual Company Directors Given the risk of potential litigation, a prudent mutual board should carefully consider whether and to what extent it owes its policyholder-members fiduciary duties and should be aware of how the appropriate exercise of those duties may differ from the requirements faced by stock company boards. While some commentators have described a policyholdermember’s interest in a mutual company as an ownership interest, there are important distinctions between a shareholder’s ownership interest in a stock company and a policyholder’s membership interest in a mutual. Beyond simply exercising its business judgment in good faith, when in Revlon mode, a corporate board has a duty to determine and effect the “best transaction” for the shareholders, typically without considering the potential impact on the company’s customers, employees or any other stakeholders who are not shareholders. Beyond simply exercising its business judgment in good faith, when in Revlon mode, a corporate board has a duty to determine and effect the “best transaction” for the shareholders,21 typically without considering the potential impact on the company’s customers, employees or any other stakeholders who are not shareholders. 22 In these situations, the role of the board famously shifts from “defenders of the corporate bastion to auctioneers” charged with achieving the best transaction. 23 A key rationale for the existence of Revlon duties is the fact that shareholders no longer hold any interest in the company following the sale of the company. As a result, a business combination in which the target’s shareholders give up their ownership interest in the corporation represents their final chance to obtain a control premium and maximize the value of their shares. Following the logic of this rationale strictly, when Revlon duties are triggered, it would be improper for a board to evaluate an offer by weighing factors unrelated to pricing or other significant deal-specific elements, such as closing conditions and termination provisions. Derivative Suits Stemming from Significant Strategic Transactions Involving Mutuals Because of members’ dual status as both policyholders and members/owners of a mutual, at the very least, one might expect the Revlon analysis to be more nuanced in the context of a business combination involving a mutual insurance company. However, that is not to suggest that fiduciary duties, including Revlon duties, should be taken lightly or that they are a mere theoretical concept when it comes to relevant considerations for mutual boards. Breaches of these obligations can lead to real world costs; for example, a class action brought by former members of Harleysville Mutual relating to alleged breach of fiduciary duty was settled in 2012 for $26 million. 24 Given the risk of potential litigation, a prudent mutual board should carefully consider whether and to what extent it owes its policyholder-members fiduciary duties and should be aware of how the appropriate exercise of those duties may differ from the requirements faced by stock company boards. We will consider below whether and to what extent the duties of a mutual company board of directors include an obligation similar to the Revlon duty directors of a stock company can owe their shareholders. Application of Fiduciary Duties to Mutual Company Boards Members of a mutual insurance company differ from policyholders and shareholders in stock insurance companies in a number of ways that are relevant to any consideration of the duties the directors of a mutual company owe to their policyholder-members. While some commentators have described a policyholder-member’s interest in a mutual company as an ownership interest,25 there are important distinctions between a shareholder’s ownership interest in a stock company and a policyholder’s membership interest in a mutual. In a stock insurance company, shareholders posses voting rights, the right to share in the company’s profitability through dividends and growth, the right to access certain information and the right to freely transfer their shares. Policyholders of stock insurance companies generally only have a contractual relationship with their insurance company governed by the terms of their insurance policy. Unlike shareholders, members of a mutual insurance company are required to be policyholders as well, and their status as members is directly tied to their ownership of an insurance policy issued if the acquirer has a controlling shareholder. QVC Network Inc., 637 A.2d at 42–43 (applying Revlon in a stock-for-stock sale involving an acquirer with a controlling shareholder). 21 Over the years, judicial interpretation of the requirements of Revlon has undergone a significant evolution. While Revlon was initially interpreted as a mandate to accept the “best price” available, the doctrine has come to represent an obligation to achieve the “best transaction,” which can include consideration of, in addition to price, various other factors such as feasibility, financing, closing certainty and the acquirer’s identity, background and future plans for the company. See, e.g., Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1281 (Del. 1989); Paramount Commc’ns, Inc. v. QVC Network Inc., 637 A.2d at 44. 22 As discussed in note 38, the requirement to ignore concerns other than deal mechanics does not strictly apply in a state that has adopted an “other constituency” statute. 23 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986). While Revlon cast the notion of the best transaction as the one with the “best price,” a more holistic view of Revlon duties has emerged over time. See supra note 21. 24 Nationwide Mutual Ins. Co., Nationwide Announces Settlement on Harleysville Policyholder Class Action Litigation (October 11, 2012). 25 See Theodore Allegaert, Note, Derivative Actions by Policyholders on Behalf of Mutual Insurance Companies, 63 U. Chi. L. Rev. 1063 (1996). Sidley Insurance & Reinsurance Law Report | 2016 5 …it is likely, and certainly prudent to assume, that a competent court examining the question would determine that directors of a mutual insurance company owe their company’s members a fiduciary duty roughly equivalent to the fiduciary duties that directors of a stock company owe their company’s shareholders. by the mutual (or, in the case of a mutual holding company, its applicable subsidiary). Unlike common stock and other securities, this membership interest is not transferable and when the insurance policy lapses, cancels or is otherwise terminated, any related membership interests are also extinguished. 26 Significantly, the Securities and Exchange Commission (the “SEC”) has relied on opinions of counsel of mutual companies to determine that a membership interest is not a security for federal securities law purposes. 27 Moreover, a mutual member generally does not have a right to share in the profitability of the mutual company through dividends28 or growth nor does a member generally have access to information in the manner and to the extent of a shareholder of a publicly traded stock company. On the other hand, certain similarities to stock ownership interests do exist: members of a mutual company generally have the right to vote in the election of directors and certain other significant matters concerning the company, including mergers and demutualizations, and they generally have the right to share in a mutual’s surplus in the event of a demutualization or liquidation. Although the issue is not entirely free from doubt, it is likely, and certainly prudent to assume, that a competent court examining the question would determine that directors of a mutual insurance company owe their company’s members a fiduciary duty roughly equivalent to the fiduciary duties that directors of a stock company owe their company’s shareholders. As in matters of corporate law generally, any consideration of the scope of a mutual board’s fiduciary duties must be analyzed under the laws of the applicable mutual insurer’s state of domicile. As noted above, there is significant case law evaluating the nature and scope of fiduciary duties owed by directors of a stock company (though much of this law resides in Delaware). In contrast, case law addressing the duties owed by directors (or trustees) of mutual insurance companies to their policyholder-members is relatively sparse. While courts in many states do not appear to have directly considered the issue of exactly what duties directors of mutual companies owe their policyholder-members, the near-universal position of courts that have considered this issue is that mutual directors do, in fact, owe a fiduciary duty to the company’s members. 29 However, these jurisdictions are less consistent when setting forth the nature and scope of these fiduciary duties. As a general rule, courts approach the question of mutual fiduciary duties in one of two ways, either (1) suggesting that the fiduciary duties applicable to boards of stock companies apply to mutual insurers wholesale, or (2) stating that stock company fiduciary duties apply generally, but allowing that such duties may be of a different scope when applied to a mutual board. 30 Unfortunately, courts taking the latter view have largely failed to provide directors of mutual companies or their legal advisers with detailed explanations of the exact differences in scope and application. 26 See, e.g., Del. Code tit. 18 § 4910 (stating that each policyholder “is a member of the insurer during the period of insurance”). 27 See, e.g., Federal Life Ins. Co. (Mut.), 2015 WL 5118692 (S.E.C. No-Action Letter, Aug. 31, 2015); Nat’l Life Ins. Co., 1998 WL 643861 (S.E.C. No-Action Letter, Sept. 18, 1998); and FCCI Mut. Ins. Co., 1998 WL 144687 (S.E.C. No-Action Letter, Mar. 30, 1998). 28 Some mutuals pay a form of “dividends” pursuant to the contractual terms of their insurance policies or in the form of policy credits. In addition, while the organizational documents of many mutual companies permit the declaration and payment of dividends to members in their capacity as members, the actual payment of such dividends (in contrast to those paid under policies) does not appear to be a common practice. 29 See Ormond v. Anthem, Inc., 799 F. Supp. 2d, 910 (S.D. Ind. 2011) (denying a motion to dismiss on the grounds that mutual boards owe fiduciary duties to their members); Rieff v. Evans, 630 N.W.2d 278, 287 (Iowa 2001) (finding that a member has standing to bring a derivative claim against a mutual company); Drain v. Covenant Life Ins. Co., 712 A.2d 273 (Pa. 1998) (same); O’Donnell v. Sardegna 646 A.2d 398 (Md. 1994) (finding that standing did not exist for a member of a cooperative, discussing the distinctions between a cooperative and mutual and implying that standing would exist in a mutual context); Elgin v. Alfa Corp., 598 So.2d 807 (Ala. 1992) (finding that a member has standing to bring a derivative claim against a mutual company); Noonan v. Northwestern Mut. Life Ins. Co., 687 N.W.2d 254 (Wis. Ct. App. 2004) (overturning a lower courts’ grant of a motion to dismiss, finding that mutual boards owe fiduciary duties to their members), cert. denied, 689 N.W.2d 56 (Wis. 2004); Lower v. Lanark Mut. Fire Ins. Co. 502 N.E.2d 838 (Ill. App. 1986) (finding that a former member did not have standing as they voluntarily terminated their status as a “shareholder” of a mutual, but stating that the member had such standing prior to termination); Heritage Healthcare Servs. v. Beacon Mut. Ins. Co., 2004 R.I. Super. LEXIS 29 (R.I. Super. Ct. 2004) (dismissing a derivative member claim for pleading particularity reasons, while stating in dicta that mutual boards owe fiduciary duties to their members); see also notes 30 and 32; but see note 31. 30 Compare Amabile v. Lerner, 166 A.2d 603 (N.J. Super. Ct. Ch. Div. 1960) (determining that a mutual is subject to the same fiduciary responsibilities as a stock corporation) and Heritage Healthcare Servs., 2004 R.I. Super. LEXIS 29 (granting a motion to dismiss for pleading particularity reasons, but stating in dicta that directors of mutual insurance companies owe the same fiduciary duties to members as stock company boards owe to their shareholders) with Silverman v. Liberty Mut. Ins. Co., 13 Mass. L. Rep. 303 (Mass. Sup. Ct. 2001) (holding that fiduciary duties exist, but expressly declining to determine the scope of those duties in a case involving a mutual merger) and Ormond, 799 F. Supp. 2d at 937 (allowing a breach of fiduciary duty claim to proceed following a demutualization, predicting that Indiana courts would determine that directors of mutual insurance companies owe fiduciary duties to their members in certain contexts). 6 An Honor Most Sensitive: Duties of Mutual Company Directors One key rationale for the existence of corporate fiduciary duties is the bifurcation of ownership (vested in shareholders) and control (vested in the board of directors) of a corporation. We are aware of one case that stakes out a minority position. In Shah v. Metro Life Ins. Co., the New York Supreme Court dismissed a derivative claim for breach of fiduciary duty following a demutualization transaction, holding that mutual boards do not owe a fiduciary duty to members and that the relationship between the mutual’s board and the company’s members is purely one of contract. 31 Although this case remains good law in New York,32 ultimately it should be viewed with caution, as the court in Shah failed to draw a critical distinction, namely, that policyholder-members of a mutual insurance company occupy two distinct roles. First, they are policyholders, with contractual and regulatory rights under applicable insurance laws and regulations essentially identical to policyholders of a stock insurance company. Second, they are members, with certain ownership-like rights in the mutual that are much more analogous to the shareholders of a stock company. In focusing only on members as policyholders, the court in Shah seemingly failed to differentiate the rights and obligations possessed by members in their capacity as members and the rights possessed by members in their capacity as policyholders. Perhaps in part because of the court’s failure to acknowledge this distinction, courts in other states have expressly declined to follow Shah when considering the question of fiduciary duties owed by mutual directors to the mutual’s members. 33 Notwithstanding the outlier conclusion in Shah, public policy considerations would seem to favor a view that directors of a mutual company should owe a fiduciary duty to their members in their capacity as members. One key rationale for the existence of corporate fiduciary duties is the bifurcation of ownership (vested in shareholders) and control (vested in the board of directors) of a corporation. Requiring directors to adhere to the high standards required of a fiduciary when managing the affairs of a corporation helps to ensure that stock company directors prioritize shareholders’ interests, even though a board’s incentives may not necessarily align with such interests. 34 This is critical because shareholders have neither the economic incentive—as they may individually own only a fraction of the company— nor the ability—as they are not privy to all of the data and information available to the board —to fully and reasonably monitor board conduct. Like stock companies, mutuals have a similar bifurcation of incentives and interests between their members and directors. Moreover, mutual members arguably have even less practical ability and incentive to monitor board conduct. Mutual membership is generally significantly more diffuse than corporate ownership, with each mutual member typically afforded one vote per policyholder or per insurance policy held, decreasing incentives for individual members to take an interest in the operation of the mutual when compared to the incentives of large shareholders of stock companies. Additionally, stock companies with at least $10 million in assets and more than 2,000 shareholders (or more than 500 shareholders who are not accredited investors) generally are required to file periodic, detailed GAAP financial and other reports with the SEC and to make timely disclosures of material developments that impact the company, including the entry into material definitive agreements and changes in the board and management. Such disclosures are not only publicly and readily available for free online, but for larger companies these reports are also scrutinized by Wall Street analysts, securities brokers and other market watchers. Furthermore, investor advisory firms, such as Institutional Shareholder Services and Glass Lewis, monitor public companies and regularly make recommendations on proxy votes. While some financial information is filed by mutual insurance companies with state insurance regulators and the National Association of Insurance Commissioners, mutual insurance companies do not have publicly traded stock and are not subject to SEC 31 See Shah v. Metro. Life Ins. Co., 2003 N.Y. Misc. LEXIS 2016 (N.Y. Sup. Ct. 2003) (determining that the relationship between a mutual and its policyholders is one of contract and that any fiduciary obligations of directors arise from statute instead of common law), aff’d as to fiduciary duties by Fiala v. Metro. Life Ins. Co., 6 A.3d 320, 322 (N.Y. App. Div. 2004). 32 See Ormond v. Anthem, Inc., 799 F. Supp. 2d 910, 937 (S.D. Ind. 2011) (“the Court believes this is an issue where reasonable minds could disagree, as evidenced by the body of New York case law holding that a mutual company did not owe fiduciary duties with respect to claims arising out of a demutualization”). 33 Id; see also note 30. 34 See generally Larry E. Ribstein, Fencing Fiduciary Duties, 91 B. U. L. Rev 899, 901. Sidley Insurance & Reinsurance Law Report | 2016 7 …where interests of members differ from the interests of shareholders in a manner relevant to a board decision, directors of a mutual company should take those differences into account in fulfilling their duties. Nowhere are these differences more apparent or more relevant than when a mutual company board is faced with the prospect of a business combination or some other material transaction. …given the high-profile nature of consolidation transactions generally and the litigation risk associated with large-scale business combinations, it is critical that mutual directors be fully briefed on and understand their duties when evaluating a potential transaction and that they properly document their fulfillment of those duties. reporting requirements, analysts and securities brokers are not regularly reviewing, scrutinizing and reporting on these companies, and investor advisory firms are not reviewing and making recommendations regarding their proxy votes. As a result of this relative lack of member and outside oversight when compared to stock companies, it is perhaps even more important that the boards of mutual companies be held to the high standard of fiduciaries when overseeing their companies’ affairs. In any event, prudent mutual company boards should assume they are subject to this high standard. In most regular, routine circumstances, the prudent exercise of fiduciary duties by directors of a mutual company would likely mirror the prudent exercise by directors of a stock company. Thus, directors of mutual companies would be wise to familiarize themselves with the detailed guidance available on how boards should properly exercise their duties, what to take into consideration, and when and how to rely on management and outside advisers in fulfilling their duties. 35 However, where interests of members differ from the interests of shareholders in a manner relevant to a board decision, directors of a mutual company should take those differences into account in fulfilling their duties. Nowhere are these differences more apparent or more relevant than when a mutual company board is faced with the prospect of a business combination or some other material transaction. 36 Mutual Insurance Companies and Revlon Business combinations of mutual companies can differ significantly in form and structure from stock company business combinations. As a result, post-transaction outcomes for members can be extremely different than outcomes for shareholders. If a stock company is acquired for cash, shareholders will be paid cash consideration for their shares and, thereafter, most former shareholders will no longer have any connection to the company. In such a situation, the Revlon duty to “get the best deal/ price” makes sense. Mutual company business combinations, however, come in a variety of forms, many of which leave policyholders with a legacy policyholder interest in the company following the transaction, even if their membership interest is “extinguished” in exchange for some consideration. This distinction poses substantial challenges for the application of Revlon in the mutual context. Despite such challenges, given the high-profile nature of consolidation transactions generally and the litigation risk associated with large-scale business combinations, it is critical that mutual directors be fully briefed on and understand their duties when evaluating a potential transaction and that they properly document their fulfillment of those duties. This is true whether the transaction impacts members’ interests directly, as in a demutualization or merger, or indirectly, as in a joint venture or affiliation transaction. While mutual boards do owe members fiduciary duties not dissimilar to the duties that corporate boards owe to shareholders, the analysis required under Revlon is significantly less straightforward in the mutual context as a result of the distinctions in post-transaction outcomes noted above. As discussed in Section II, in the sale of a stock company that triggers Revlon duties, price and other significant deal-specific elements, such as the form of consideration, financing and the likelihood 35 See In re Caremark International Inc. Derivative Litigation, 698 A.2d 959, 967 (Del. Ch. 1996) (discussing the responsibilities of stock company boards to monitor the company’s compliance with law while holding that a proposed settlement of a fiduciary duty claim against the directors of a healthcare company was reasonable after the company paid substantial criminal and civil penalties following allegations of kickbacks to contractors). 36 A thorough discussion of the forms of mutual company business combination and other material transactions is beyond the scope of this article, but can include, among others: (i) a sponsored demutualization, where the mutual insurer converts to a stock company and is simultaneously acquired by another person or entity, in which the mutual’s members relinquish their membership interests in exchange for consideration that may take the form of cash, policy credits, stock or the right to acquire stock in the company or the acquirer; (ii) a mutual merger, where the mutual enters into a merger agreement with another mutual, and the members of the mutual and the members of its merger partner become members of the combined company; (iii) an affiliation, where the mutual enters into an affiliation agreement with another company that provides for the sharing of business functions such as underwriting, reinsurance, claims handling, and/or asset management and potentially involves the mutual ceding control of the board of directors to the other company; (iv) a traditional demutualization, in which members relinquish their membership interests in exchange for consideration or subscription or other rights, typically achieved through an initial public offering or similar capital raising transaction; (v) a joint venture, where two parties combine operations either by contractual arrangement or by contributing to a new, jointly-owned enterprise; and (vi) a mutual holding company or similar corporate restructuring. 8 An Honor Most Sensitive: Duties of Mutual Company Directors …an argument can be made that mutual directors should, in addition to considering price and other dealrelated terms, give substantial weight to the stability and reputation of the acquirer and the surviving entity, since that is likely to be a primary concern of the members with respect to a proposed change of control or some other transformative transaction. …because mutual members are also policyholders, it is not clear that price would or should be the sole overarching concern when evaluating a potential transaction (as it clearly would be for the vast majority of shareholders in a stock company considering a similar transaction). of closing, are typically thought to be the most important considerations for a board. Much like a stock company sale, in a mutual change of control, price and other dealspecific elements related to a potential transaction are crucial factors that directors should carefully consider to satisfy their duties as directors of their company. However, because mutual members are also policyholders, it is not clear that price would or should be the sole overarching concern when evaluating a potential transaction (as it clearly would be for the vast majority of shareholders in a stock company considering a similar transaction). Critically, a mutual member’s interest in the company is not fully extinguished upon the consummation of such business combination, because the member’s status is inextricably linked to their status as a policyholder. As policyholders, members are likely to remain very interested in many aspects of their insurer following a business combination. Among other things, policyholders will rightly be concerned with how well their insurer will be managed, whether it will be able to meet its obligations to its policyholders over time, and whether the business combination will result in increased premiums or reduced benefits under their insurance policies. If one accepts the premise that these are legitimate concerns of members, then it follows that a board, when prudently exercising its fiduciary duties, should also be able to take these and other legitimate concerns into account when evaluating whether to pursue any particular business combination, even one that results in the extinguishment of the policyholder-members’ membership interests. Take, for example, a life insurance policyholder, who pays premiums today for the expectation of a payout in years or even decades in the future; a sale to a company with a lower A.M. Best Company rating or poor track record of dealing with its policyholders may create a greater risk that, following such a sale, the insurer is less likely to be there to pay insurance claims in the future. Therefore, because mutual members are, by definition, also policyholders of the mutual, a strong argument could be made that a mutual board should not blindly seek the best price, even in a transaction where the Revlon duty would otherwise appear to apply. Indeed, an argument can be made that mutual directors should, in addition to considering price and other deal-related terms, give substantial weight to the stability and reputation of the acquirer and the surviving entity, since that is likely to be a primary concern of the members with respect to a proposed change of control or some other transformative transaction. In considering the extent to which the Revlon standard should be applied in the context of a mutual business combination, it is useful to recall that the primary rationale for Revlon is the extinguishment of a shareholder’s ownership interests following a change of control, which is the totality of most shareholders’ interests (i.e., any shareholder that is neither an employee nor a customer of the target company). Because such a transaction represents a shareholder’s final opportunity to maximize his or her investment, it is often argued that this obligates the board to manage an auction process in such a way as to protect the shareholders’ “right to obtain a control premium.”37 Whether or not this interpretation is an unduly restrictive reading of what Revlon actually requires, its underlying rationale is not strictly compelling in the context of a mutual business combination given that, as noted above, a mutual member’s interest is not fully extinguished following a merger or sale. This distinction suggests mutual directors should have greater flexibility with respect to satisfying their fiduciary duties to members in evaluating a takeover bid and/or running an auction and that they should be permitted to afford comparably greater weight to the effects of the proposed transaction on members in their capacities as both members and policyholders. 38 37 See, e.g., In re Smurfit-Stone Container Corp. S’holder Lit., 2011 WL 2028076, *13 (noting that Revlon applies when “there is no tomorrow for the corporation’s present stockholders, meaning that they will forever be shut out from future profits generated by the resulting entity”). 38 Furthermore, consideration should be given to whether there is an applicable “other constituency” statute that would permit directors to consider factors other than deal terms when evaluating a potential acquirer’s offer. Other constituency statutes typically expressly allow directors, in evaluating transformative transactions, to weigh numerous factors besides deal terms, which, in an insurance industry context, could arguably include the proposed acquirer’s reputation with respect to claims handling, in addition to the impact that the transaction may have on various non-shareholder (or non-member) stakeholders, such as the company’s employees, suppliers and the local community. However, to the extent another constituency statute applies, given wide variations in statutory wording and the lack of interpretive guidance for courts to rely on, such Sidley Insurance & Reinsurance Law Report | 2016 9 …given the possibility of legal challenge following the consummation of any large-scale transformative transaction, a prudent mutual board contemplating such a transaction should assume that the full body of corporate fiduciary duties applies to their deliberations and decisions, including, in some form, the requirements of Revlon. Conclusion While a handful of courts have addressed the issue, in most jurisdictions, there is no definitive legal guidance on the scope of the fiduciary duties mutual boards owe to the company’s members in the context of a significant strategic transaction. Although the substantial legal authority concerning corporate fiduciary duties provides some guidance, there are key differences between the structure of mutual insurance companies and corporations that may impact the necessary analysis. Additionally, there are compelling policy arguments that some corporate fiduciary duties, in particular those required by Revlon, should not be applied wholesale to mutual boards because the interests of members are not necessarily extinguished in a change of control transaction and members’ concerns with respect to such a transaction are apt to be very different from the concerns of shareholders confronting a similar situation. Nonetheless, despite such structural distinctions and compelling policy arguments, given the possibility of legal challenge following the consummation of any large-scale transformative transaction, a prudent mutual board contemplating such a transaction should assume that the full body of corporate fiduciary duties applies to their deliberations and decisions, including, in some form, the requirements of Revlon.