EMAG meeting with Equitable Board on 1 Dec 2000

Legal Agenda Item

Draft of 27 Dec 2000

This is a draft transcript based on longhand notes taken at the meeting and offered in good faith as recording the substance of the discussion. There is no claim that the discussion is represented verbatim. A very few points have been omitted for reasons of diplomacy.

Ms Elizabeth Gloster QC, who represented the Society (and hance also the non-GAR policyholders) in the House of Lords was present for this part of the discussion with the Board.

Agenda for the Legal discussion presented here:

• We are conscious that the interpretation of the ruling of the Courts when taken together with the discretionary management practices of the Society creates a situation of unfairness towards the 'non -GAR' policyholders.
• The advice we have is that a representative action on behalf of a 'non-GAR' policy is possible and probably necessary. The effect could be beneficial both to that class of membership, and to the Society taken as a whole.
• In any case, the potential for such an action increases the uncertainties surrounding both the present and the future management of the Fund.

AHJ

From 1988 the Society issued policies without Guaranteed Annuity Rates (GARs). Interest rates were then high and there was relatively little difference in the investment positions required for the different classes of policies. GAR and non-GAR policies were administered as similar policies.

From 1988 onwards, as interest rates fell, the GAR policies needed an increasing level of investment in secure funds to underwrite the guaranteed terms. By 1993 the situation was intolerable, it being necessary to place the whole contribution into secure funds to meet the guaranteed term. There was very little free profit deriving from the GAR policies after this. The non-GAR policies with less restraint on investment in equities yielded more profit as a result of the greater investment freedom.

Today the position has been reached where for each additional contribution to a GAR policy the contribution alone is not immediately sufficient to fund the (GAR) contractual obligation.

Our view is that these two classes of policies were never the same and could never support the same investment strategy

The non-GAR policies allowed a relatively free investment regime.

The GAR policies included a capping rule - under certain conditions a different regime of payment would arise; this point was first reached in 1993. At this point policy values ceased to be actual values and became nominal values (as with gilt stock). {This is a necessary conclusion because the annuities offered have a greater present value than the 'policy value' upon which they are based} . This contrasts with the non-GAR policies in which the policy value is always the actual value.

The Society has argued that there is a single with-profits fund. This is a practical device where every policy enjoys a part of the fund. But they do not benefit in equal measure. There are working rules for determining the share of the fund attributed to different policies. The profits are apportioned according to the size of a policy holding, and the nature of the policy, and in the case of GIRs, economic considerations.

The single with-profits fund provides a practical means of administering funds. It enables a single treasury operation, and improves the efficiency of external transactions. For example, if there were two separate funds, the fund managers might be selling and purchasing similar equities at the same time. This would involve the creation of unnecessary external transactions, and higher transaction costs.

But in truth, the single with-profits fund is already in effect two sub-funds, one of secure investments (gilts etc.) and one of free investments (equities). The ratio of the two being dependent upon the aggregate position of the Society in terms of guaranteed obligations for which a backing of secure funds is required. Each new contribution to a policy causes an incremental change to both of the sub-funds, to the levels of secure and free investments. The proportions of the incremental changes depending upon the nature and requirements of the contributing policy. Likewise, when policies mature, the decrements to the fund involve a release of guaranteed obligation, and a release of free funds. The proportion of the two, again being dependent on the policy, and the fraction of funds guaranteed at the time of maturity of the fund. On a day to day basis the fund managers look only at the aggregate of guarantees, and move funds between the secure and the free sub-funds so as to respond to market changes and maintain the security of the guarantees. However, at any point in time, the makeup of the fund comprises the aggregate of the policy risks and obligations. As individual policies contribute to the two subfunds in different measure, there would appear to be no reason why they should not benefit from the two subfunds in different measure. This is the policy that the Society has already adopted with respect to the GIRs, but has denied to the GARs.

A with-profits investment could not be expected to be as secure as, say a simple Building Society account, but offered potentially better returns. The GAR policies would always have lower upside expectations than non-GAR policies, but they also had lower downside risks.

AN

You have raised a huge number of issues. In 1988 the GAR series of policies ended and the non-GAR series began. It is not right to regard them as very different policies with different investment requirements. There is a single common with-profits fund catering for a wide variety of policies, single premium, multiple premium, life assurance, bonds etc. It is a common fund. It is the actuary's responsibility to ensure the appropriate bonuses are added: to ensure that returns for the policies are appropriate.

AHJ

GAR and non-GAR contributions must imply different commitments.

AN

That would be right if we had had the House of Lords ruling in 1988. But that was not the case. We had been running the business for 5 years on the basis of differential final bonuses.

AHJ

Non-GAR policyholders were suffering before the GAR case arose. Investment returns to non-GAR policy-holders have been reduced by the need to meet guarantees on the GAR policies.

AN

No, the investment philosophy has been the same.

AHJ

Of course they have suffered; non-GARs would have had a higher yield. Now in the case of so-called Guaranteed Investment Returns policies (GIRs) there has been a different treatment. The GIR obligations are fixed contractual obligations similar to the GARs and arise whether the fund is in profit or not. In the case of the GIRs the Society has regard to economic factors and reduces the allocation of profit to policies containing GIRs.

My own principal policy was taken out in 1987 and has a GAR. My wife's was taken out in 1988 and has no GAR. If we had thought for a moment that the investment approach would be as you describe we would not have taken out this second policy.

AN

There was no disadvantage to the non-GAR policies before 1993.

AHJ

Not so. Had the security demands of the two policies been properly taken into account it would have been seen that their returns were different. We do not accept that the non-GAR policies were correctly managed after 1988.

CH

The investment strategy would have been the same if there had been no pre-1988 policies.

AHJ

But they did not benefit as much. More secure funds are needed for the GAR policies. Non-GAR policies are inherently more profitable with greater risk.

We are here for an exchange of views. In our view the injustice started in 1988. The House of Lords ruling just aggravates the injustice.

AN

Are 2.5% policies different from 3.5% policies?

AHJ

The single fund is just an administrative device. There can be no suggestion that the non-GAR policy-holders should be made to pay for the security of the GAR policy-holders.

AN

Are you saying that we have been running the fund incorrectly?

CH

There is a clear bridge to the legal point. I would agree with you if the House of Lords ruling had been known in 1988.

AHJ

The House of Lords ruling is not the point at issue. We are talking about the relation between investment strategy and contractual obligations.

CH

The benefits to the different classes of policy-holder were equal. In the late 1980s investment conditions were such that the GAR had little value. By 1993 we had had 5 years of non-GAR business and most GAR policies had built up a fairly substantial final bonus. That gave headroom to absorb the benefits by differential bonus.

Things were changed by 1998, when the headroom started to become insufficient.

In the future GAR policies may have differential rates.

AHJ

You must agree that the Society was not bound to administer the GAR and non-GAR policies in the same way.

AN

Correct.

AHJ

Originally the non-GAR policies were at a very small disadvantage. By 1993 investment opportunities had diverged very much.

It is sad to see a lack of rationality in the practice of the Society which was the first to introduce a rational basis for life assurance.

AN

We could have operated in the way you suggest. We would have invested GAR premiums and funds more conservatively. We felt that operating a differential bonus policy was the fairer way.

AHJ

You gave the same bonuses to different classes of policy.

AN

I disagree that the option for guarantee had an additional expense.

VN

I must disagree at that point.

AHJ

These were different kinds of policy. We don't imagine that the Society set out to disadvantage anyone. The full scenarios were perhaps not considered. There can be no question that the full range of scenarios required the Society to act differently from the current mix.

CH

Each with-profits office manages its own business in its own way. We never led anyone to believe that we would partition the with-profits fund.

AHJ

The GAR option was a very real advantage.

AN

Well, we could have run it in a different way since 1988.

AHJ

It would have been a rational way.

JL

Let me start by thanking EG for informing me about the House of Lords case and visiting me to help me further. Despite her assistance I have continued to worry about the non-GAR policy-holders. I also thank DWS for their letter yesterday.

I want to deal with the legal question fairly economically.

There are three issues:

Is the door still open at all to non-GAR policy-holders to question in the courts the diminution in their share of the cake resulting from the House of Lords ruling?

Whether - even if the gates are open - they might be able to get over their loss of share; is there reasonable hope for them?

If there is any hope then does one recover that previous position, or would such action interfere with other initiatives?

I hold a very simple view - it may be described as a simplistic view. The non-GAR policy-holders have suffered a grievous loss of savings: even a growing or ongoing loss as GAR contributions flow in.

There is a basic disagreement between the Society and the non-GAR policy-holders. Economically different circumstances should have been reflected in ultimate values. The Society doesn't agree. At no point has there been anyone on the legal side to consider the positions and interests exclusively of the non-GAR policy-holders - to put the matter exclusively from their point of view even if it led to some egg on the face of the Board - perhaps not the same individuals as the current Board.

Until the extreme step of proceeding to the House of Lords the lack of exclusive non-GAR representative perhaps didn't matter. When the matter came to the House of Lords a new question arose - as we can now see - given a difference of view between the Board and the non-GAR policy-holders. That question is: ``Whether the Board has discretion when allocating bonuses between the GAR and non-GAR policy-holders''. All around the table must agree that the decision of the House of Lords on this point does not command the usual respect.

What is to be done at this stage?

EG

I fear that this account is factually wrong. Ring-fencing was raised at the first stage.

JL

Yes, but not for decision.

We now need a white knight for the non-GAR policy-holders. The only way to put right the injustice is to go back to court and put to the court the case that it was not practicable for the Society to put the full non-GAR case to the courts; that could get the door open.

My colleagues at DWS and EG must be much more familiar with the detail of the case than I. What is now required is to get an independent QC to determine whether a case can be made. We should agree a set of instructions for the QC to review and to tell us - is such a case possible? futile?

If JL's opinion is refuted - then JL will shut up. It would be wrong at this stage not to bring on someone new who is made aware of the difference between the Board and the non-GAR policy-holders, hearing what EMAG and the Board say. It would be wrong to reject the chance to vindicate the rights of the non-GAR policy-holders - to reduce the `black hole'. Why should this be bad for purchasers? One could write conditions into the sale agreement which would increase the price retrospectively should the black hole be reduced by a win. We are not looking for adventitious bonuses for the non-GARs - we are looking for a fair share.

Finally, if we do not take this action there is always the possibility that some policy-holder, or the Pensions Ombudsman, might have a go.

VN

We are asking to proceed in two stages. Firstly, to get an authoritative independent legal opinion. Then to meet again and decide what to do next.

AN

Can we have legal comment on whether the doors to the courts could still be open?

EG

JL knows my views. I have advised the Society that the door is not open to further action. The House of Lords has determined the issue conclusively. A representation order was made at the first stage which obliged the Society to represent the non-GAR policy-holders. I remind you that I was not involved when the case was heard before Richard Scott or at the Court of Appeal.

The original summons raised issues relating to allotment of final bonus. However, throughout the proceedings the issue was addressed more broadly as relating to differential bonuses. The Society addressed the issue as between the GARs and non-GARs. They presented evidence that to abandon differential bonuses would not be equitable to non-GAR policy-holders and would not reflect asset share, not reflect the interests of the two classes of policy.

There is a suggestion that the courts and House of Lords did not appreciate the consequences. The fact that equal bonuses would not reflect asset share was spelt out in the House of Lords by myself - the non-GARs would have to pay the GARs' inflated bonuses. The issue was all there. Now the ring fencing decision must be considered. It was absolutely clear to us that it would be unclear not to take the ring-fencing decision. I represented the Society and the non-GARs on the matter of ring-fencing and we lost. The decision was binding on all parties represented even if that is not clear from the court record.

VN

The flip side to this is mis-selling to the non-GARs.

AHJ

All we can see is the court record. The High Court saw the GAR policies as non-GAR policies with a cherry on top. It was an elective decision by the Society to treat the GAR and non-GAR investments according to the same strategy. We can see that the non-GARs have never been independently represented. The two classes of policy should never have been given the same bonuses. They were simply different financial vehicles.

EG

You are saying that GAR policy-holders had never paid a price for the GAR option? Is the idea that the Board prior to 1993 was wrong vis-a-vis the non-GAR policy-holders - that they did not treat the non-GAR funds correctly?

AHJ

I have no sympathy with the Board's previous differential bonus approach.

JL

I would be less critical. The House of Lords argument supposes a choice given GAR and non-GAR policies. But they were never sold side by side.

Don't we have a duty to find out whether the issue can be reopened?

AN

If you are right our problem would disappear. Of course, uncertainty and delay would reduce the Society's value. We don't want the sale process longer drawn out. The advice we have had is that there is no chance of reopening the House of Lords decision.

VN

We are asking for a second opinion. Someone to act for the non-GARs independent of the Board - someone to give us a view as to whether JL's concerns and possible remedies are reasonable.

AN

This will get to our current prospective purchasers. That would be disastrous.

AHJ

It will eventually get to the Ombudsman in any case.

AN

They might conclude that a sale might not be necessary.

AHJ

If a buyer sees it - why can't you?

JL

Given the present circumstance it is reasonable now to effect a sale. But the rights of the non-GAR policy-holders should be heard.

EG

Your argument requires that the Society had separate notional funds.

AHJ

No - it already handles GIRs differently without this.

CH

Please explain.

AHJ

The GIR term is a contractual obligation unrelated to the profitability of the Society. But the bonus is reduced by the GIR. Hence an economic rule is applied to discriminate against policies containing GIR terms even though there is no separate fund.

JL

Our argument is that the Society was not in a position to represent itself and the non-GAR policy-holders.

EG

They had identity of intent.

JL

The argument involves saying that the Society was mistaken. The funds should have been treated differently from day one.

EG

So what? Where is the issue of substance to be decided? Separate representation is no good without an issue?

VN

We are getting into detailed issues when we should concentrate on the proposal to get new counsel to look at the non-GAR case - uncontaminated by duty to the Society.

JL

If the Society appoints a QC we will cooperate and assist. If not we must reserve our position. This need not affect a sale - it can be taken into account in the terms of sale.

CL

We didn't want to be in this position. But it is a matter of breach of contract. Economic characteristics are of no relevance.

VN

Remember that you need 75% approval for a sale. We are asking you merely for a second opinion. You are so confident that it will not change anything - why will you not agree?

CH

The GAR policy-holders might start action again!

AHJ

There was no reference to the non-GARs in the House of Lords decision. Now this is a difference between the non-GARs and the Board.

EG

What is the issue that can actually be opened up?

JL

We must go back saying that the House of Lords cannot have meant what it is said to have meant. I cannot accept the idea that the Board is deprived of discretion in managing the policies by 12 lines of judgement of which only 6 are reasoning (NOTE: this refers to the ring-fencing decision). It could be construed very restrictively.

AN

Suppose I accepted that the Society was in error after 1988? What is the probability of success?

JL

I have not had the opportunity to peruse all the papers in the case.

It seems very odd to me to suggest that policy-holders should have expected the Board to have pursued an economically irrational bonus policy. The House of Lords seems to be saying that what happened ex post can be implied into a contract ex ante. That cannot be right.

The Counsel for the Society cannot reasonably have been asked to present arguments that the Board had acted wrongly.

AHJ

A second opinion needs input from the Society as well as EMAG.

JP

We have had a thorough discussion to date. Can we offer EMAG a carefully written response?

EG

Are we talking about re-opening the same issue or not?

JL

Yes, really.

EG

But also that after 1988 the Society should have been doing business differently?

JL

It was not made clear that first GAR policies were being sold - and then non-GAR. Hence there can be no implied term.

If AHJ is right that economically rational policies should have been pursued - what other could be expected? - then one cannot infer an implied term which relates to economically irrational policies.

CH

AHJ expounded one way in which the business could have been run - but are others irrational?

AHJ

It has been overlooked that the GAR policy holders did have a thing of value. In troubled financial times they were able to look at their policies and know with certainty what their eventual entitlement would be. This was a fact not put to the Courts. The GARs had assurance - quiet assurance.

AN

We will reply in writing within two weeks. But we must ask that this discussion be held strictly confidential for that term.

EMAG members

Agreed.