Mr. Michael Foot
Managing Director
Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
T: 020 7676 5000
F: 020 7676 1013
m.foot@fsa.gov.uk

Dear Michael,

Accountability and mutuality: lessons from the Equitable Life:

I write further to our recent telephone conversation on behalf of the Committee of EMAG. You said you would welcome our thoughts about the accountability and governance of mutuals, an issue included in the Sandler review.

Provision of information - the foundation of accountability

I am pleased to report that Mr. Treves tells us that he asked Halifax in early June for clearance to provide us with detailed information about the Halifax deal, but he advises us there has not yet been a positive response. We remain, however, dissatisfied with the board's refusal to provide the members with information about the financial review which the Society undertook and was the basis of cutting policy values effectively by a fifth on July 16th. Although the Compromise consultation document includes numbers, it still does not share with members the financial state of the Society¹.

There are two fundamental reasons why some version with hard numbers of the financial review should be available to members, one of principle and one of practical significance:-

• Many members have seen their apparent wealth reduced by tens of thousands of pounds. We - the owners of the Society - believe we have a right to a quantified explanation about our money. Furthermore we want members (and professional advising them) to be able to see for themselves that the fund is stable and not to read just the drip drip of uncertainty in the press speculation.

• There has been something of a run on the Society with tens of thousands of members wanting to withdraw since the devaluation. We think part of the reason for this situation is the way in which the Society mishandled its communications regarding the "hit", both in not addressing the concerns of the press and in not providing the underlying information.

Although there may be a valid reason for providing no information, we have been given a succession of reasons that we regard as totally unsatisfactory. The Chief Executive claimed that "Members have already been given all the information they need [about the review]. They have been told that assets are now sufficient to meet the liabilities". How do we know? Why should we believe him when he claimed in roadshows in March that "It does not matter how many people leave - they are cash neutral to those who remain"? He was wrong.

Another board member has written "It would not be surprising that, if the details of the judgements made by the Board on all these issues² were made public, some commentators would find them controversial and questionable. Such controversy would do nothing to serve the interests of members as the Board strives to construct a compromise that is fair to them all". We do not for one moment accept this essentially paternalist view, which has been the partial cause of the continuing widespread distrust of the Society. If the Equitable knew how to communicate properly, there should not be a problem. In any case "democracy" is a messy business. As Churchill observed "It has been said that democracy is the worst form of government except all those other forms that have been tried from time to time".

We are not the only ones concerned about Equitable's reluctance to provide information. The report by Bacon & Woodrow dated 25 July to the Principal Civil Service Pension Scheme observed (my italics):-

"One question is whether the amount offered on transfer to another policy is "fair value" - for which the best guide is probably asset share. Unfortunately only Equitable Life has sufficient information to be able to calculate the member's asset share. One is forced to trust what Equitable Life say - and trust is at a low ebb at present".

"There seems little real upside and plenty of potential downside risk. However the underlying investment or economic position remains impossible to analyse but our feeling is that there is now a more penal element in the surrender terms than before. This would be a 'penal' element relative to the concept of asset share - which in itself is not something that members would easily understand and where only Equitable Life know the "true" position".

"Trustees need to press Equitable Life to release information to enable members to decide whether or not to stay".

We hear that there has been pressure from the FSA on IFAs not to make recommendations regarding staying or leaving the fund. Add to that an information black out on the Society's finances - just how is anyone supposed to judge in a rational way what to do?

Weak governance

The Equitable, like many (if not all) mutual life organisations, is constituted as a company which perhaps leads to a tendency to think that the governance and behaviour of a large mutual should be like that of a plc. But a mutual life office - even more so a closed and "virtual" mutual, which is in effect a private investment club - is very different to a plc in a number of crucial respects:-

• much - if not most - of the material that comes before a plc board is confidential because it is stock market, product market or personnel sensitive. We doubt the same is true for the board of Equitable. Some information is for a time "member sensitive" in that all members should receive it at the same time, but information which is not genuinely confidential should be provided to members

• whilst one can sell plc shares easily and cheaply and so get out, most members plan to be in a life fund for the long haul, and cannot get out from it at a low transaction cost. Annuitants are, of course, locked in.

• the governance of mutuals is subject to very weak constraints. There is no product/profit market discipline; there are no large institutional shareholders to push directors out; and the mechanisms that are theoretically available to allow members to express their will about the strategy and performance of the board - the ability put a resolution to the AGM and to call and put a resolution to an EGM, and the ability to vote representatives onto the board - are not effective, which we show below

Weak governance facilitates a tendency for mutuals to be hijacked by "managerialist interests" at the expense of the interests of the mutual owners. (We do not, however, suggest that the current board is hijacked in this way). For example:-

• the Equitable ran a highly bonused sales force whose incentive was to sell policies regardless of whether they were in the interest of the members. The Equitable's provision of £153m for pensions mis-selling, which although fortunately modest compared with some other life offices, illustrates the incentive to sell. More recently the incentive to sell may underlie cases of mis-selling when sales people were claiming to some prospective policyholders that they would be insulated from the House of Lords decision

• in the early 1990s the Nationwide Building Society pursued a managerial objective of growth by offering new investors higher rates than existing investors, yet (along with mortgagees) the later were notionally the owners of the Society

• last year Standard Life reportedly spent £10m of its members' money persuading them that the Society should remain a mutual. A report of the annual general meeting by the Financial Times (28 June 2000) quoted one member referring to a "biased and inflammatory campaign that put one point of view and not the other"

The obstacles to direct action by members

There is nothing in the Memorandum and Articles of Association of the Equitable that provide for members either to put a resolution to the AGM or to call for an EGM, and so members have to fall back on the provision in the Companies Act that an EGM must be called if holders of 10% of the shares require it. Although getting support of 10% of the votes of a FTSE company only requires the fund managers of a few major institutions to telephone each other, getting 10% of the Equitable's voting members to support a resolution would require a mail shot to all members. The cost of sending a letter to 450,000 members would be of the order of £125,000, which is prohibitively expensive for members or an action group dependent on, at best, modest subscriptions.

The voting for directors can be "arranged" so that those whom the chairman and incumbent board want elected are voted in. At first sight the results of the recent vote at the AGM for new directors appear to show overwhelming support for the recommended directors, each of whom gained an average of 386,400³ votes and 73,698 against, and little for the "independents", each of whom gained an average of 81,616 votes and 376,698 votes against. But further analysis shows that the voting results were largely dependent upon chairman's mandated proxy votes and his free proxy votes⁴. The majority of votes cast for those elected and against the "independents" were proxy votes cast by the chairman.

We accept that the current voting system was appropriate for the crisis situation and that it has provided us with a good board. Nonetheless the foregoing highlights the fundamental problems with elections to large mutuals, namely:-

• few can be bothered to vote - even in the well publicised condition of the Equitable only 12% of the members bothered to vote

• the voters do not know what the candidates are like and in consequence many "subcontract" their voting rights either to those whom the board recommends or to the chairman

We accept that the chairman and the incumbent board should have a say in the election of some of the board members, and are aware a completely free vote could result in the election of a board lacking the necessary professional skills. We do not, however, believe that the existing board or the chairman should have what amounts to patronage of them all because it may result in packing the board with trusties, all of whom are to varying degrees beholden to the chairman for tenure.

We note that the Cadbury report enjoins non-executive directors to bring "an independent judgement to bear on issues of strategy". One of the directors of the Equitable has written that the "directors debate matters freely, openly, and from a number of different points of view". They may well do, but how do we know? To adapt a phrase, "Independence should not only be done, but seen to be done". Perhaps if one or two of the "Old" Equitable board had exercised genuinely independent judgement rather than accept the "Aylesbury" line, we might not be in the current mess.

We do think that in a Society the size of Equitable Life it is appropriate for directors to be appointed who are not "substantial" members of the Society, yet fully half of the current board have taken out token £1000 policies. The board could no doubt have benefited from their type of wisdom either by employing consultants or employing them as consultants.

In criticising the way in which the board has been elected and in saying that we do not think directors should be parachuted in with £1000 policies, we are not criticising the abilities of the current board members. Rather we are drawing attention to the long run need for an institutional framework that strengthens the governance of mutuals and ensures that they are directed by genuine members. We believe there should be a number of directors who are elected on a "free vote" and who are independent of the chairman, whose role is clearly to act as "checks and balances" and if necessary to "throw grit in the system".

Recommendations

We recommend that the FSA should not wait for the Sandler review before issuing a code of "best practice" to address some of the issues we have highlighted. For example the code might:-

• Remind the directors and senior staff of mutuals that they are owned by the members and that, subject to genuinely confidential issues, the members should be informed of significant commercial matters affecting their interests

• Recommend that the Memorandum and Articles of Association are written so that they allow reasonable opportunity for members to put resolutions to an AGM and so that a reasonably small number of members can call EGMs. For example in the case of Equitable it could be 1000, which would provide a serious enough hurdle to eliminate vexatious motions

• Recommend that directors have a minimum value policy holding of, say, £25,000 and also the values of all directors' policy holdings are published in the Annual Report and Accounts

• Recommend that three or four independent directors should be chosen on a completely free vote with no chairman or board recommendations on the candidates for these positions and no proxy votes cast by the chairman. (This provision is analogous to section 16 of the Pensions Act of 1995, which requires that a third of trustees of a company pension fund should be members of the fund). "Independent" candidates should have a right to speak at the AGM if they wish

• Ban negative voting, which is a consequence of the Companies' Act provision of putting a resolution requiring a for and against vote. The process can result in confusing members, and could lead to idiosyncratic results. The voting might be that members are provided with a list of X names and they vote for Y of them (Y < X)

• Spell out the responsibilities of an appointed actuary to the members. The position should be independent of the board.

Yours sincerely,

ALEX HENNEY

for and on behalf of the EMAG committee

c.c. Equitable Board Members.