Equitable Life - A Lawyer's View

Imagine this?

Six people ("policyholders") invest for their retirement in the with profits fund of a life insurance company.

Shortly before retirement, each policyholder has a fund, including guaranteed bonuses, of £700. At their retirement, there is £1,000 in the fund due to each policyholder's contributions (i.e. an "excess" of £300 for each policyholder).

Guaranteed annuity rates

George, Graham, Greg and Geoff all have policies with "guaranteed annuity rates" ("GARs"). The effect of the GARs is that, at retirement, each GAR policyholder can use their guaranteed fund of £700 to buy a GAR annuity worth £1,000. This is a guaranteed "right" under the policy.

The GAR annuity is a single life annuity from age 65 with no indexation. Graham and Geoff are happy with this. However, George wanted a joint life annuity for himself and his wife, and Greg is also considering a joint life annuity.

Neil and Nigel do not have GAR policies. They started investing a few days after the others. They paid the same as the others (in fact, slightly more), but their policy terms do not include GARs.

Discretionary bonuses

There is £1,000 in the fund due to each policyholder's contributions. The GAR policyholders are already entitled to benefits worth £1,000 each. This leaves a "surplus" in the fund of £600 arising from Neil and Nigel's contributions.

The directors of the insurance company have to decide how to divide this surplus between the policyholders in the form of a "terminal bonus". The directors have total discretion under the rules about which policies should get a terminal bonus and how much they should get.

What should the directors do?

The directors would like to give £1,000 to each of our six policyholders (i.e. they would like to give the £600 arising from Neil and Nigel's contributions to Neil and Nigel). However, this still leaves a problem. A GAR policyholder who does not choose a GAR annuity will get only £700.

The directors decide to avoid this problem by giving GAR policyholders an extra benefit. If a GAR policyholder does not want the GAR annuity worth £1,000, the directors will give them a special bonus of £300. They will then have a fund of £1,000 with which to buy a different kind of annuity.

Unfortunately, the judges then interfere.

What do the judges say?

The judges say that the directors cannot give GAR policyholders a special bonus if they do not choose a GAR annuity. The directors must take money from everyone who does not want a GAR annuity (including other GAR policyholders) and give it to the GAR policyholders who do want a GAR annuity. (This may be why few judges are directors of life insurance companies.)

The judges say that the directors must first give £1,300(see Note 1) to George and Graham. What happens next must depend on whether Greg chooses a joint life annuity.

• If Greg chooses a joint life annuity, the directors must give £1,075 to Geoff and £775 to Greg, Neil and Nigel.
• If Greg chooses the GAR annuity, he and Geoff get £1,000 and Neil and Nigel get only £700.

How can this be?

If the GAR annuity is worth only £1,000, how do George and Graham get £1,300? Obviously, the GAR policyholders are each entitled to a GAR annuity worth £1,000 (and nobody can argue with this). However, this surely leaves £300 each as a terminal bonus for Neil and Nigel?

This is the clever legal bit!

Apparently, the directors' discretion is subject to an unwritten "implied" term! This comes as a bit of a surprise to the directors, and to everyone else who thought words meant what they said.

The rules say clearly enough that it is for the directors to decide which policies should get a terminal bonus and how much they should get. But the "implied" term, visible only to specially "gifted" judges, contradicts this! The implied term says that all policyholders who retire at the same time must get the same bonus, whether or not they have a right to a GAR annuity.

Hang on a moment?

If everyone gets the same bonus, this should surely mean that all the GAR policyholders in my example should get £1,100 and Neil and Nigel should get £800?

This is the best bit!

George and Graham retired last year when the directors still thought the rules meant what they said.

George and Graham each got benefits worth £1,000. George got a terminal bonus of £300 and bought a joint life annuity. Graham did not get a bonus because he chose a GAR annuity worth £1,000.

• Graham now has to be given the same bonus as George, so Graham gets an extra £300.
• George has claimed that, had he known that he could have both a GAR annuity and a bonus, he would have chosen to have both (like Graham). The insurance company must therefore compensate George by paying him an extra £300 as well(see Note 2).

Since George and Graham each get £300 more, there is nothing left to provide a bonus for any of the other policyholders (unless Greg chooses a joint life annuity).

Why might Greg get only £775?

Greg would prefer not to buy a single life annuity with his savings. However, if he chooses a joint life annuity, the £300 that would otherwise have been needed to provide his GAR annuity will become available for distribution as terminal bonus.

The judges say that everyone must get the same bonus, so the £300 cannot be used to provide a bonus for Greg alone. It must be shared with Geoff, Neil and Nigel who are retiring at the same time. Each of them gets a £75 bonus, giving Geoff £1,075 and the others £775 each.

Is this fair?

Neil and Nigel have each been heard to say (after Ian Hislop): "If this is justice, I am a banana!". Greg has been heard to say that he would have preferred the choice given to George and Graham.

George says that GARs were intended to provide policyholders with something of value. His GARs would have had no value if he had not also been entitled to the same bonus as Graham. If he had got a smaller bonus, he would effectively have had to pay for his own GARs himself! The judges agreed that it was outrageous for the directors to expect George to pay for his own benefits!

(Wouldn't it be nice if we could all rely on the judges to make someone else pay for our benefits!)

The Equitable Life case

The above scenario may read like farce. It is not. It is tragedy. It is the Equitable Life situation.

Let us be clear about one thing. Equitable did not renege on any guarantees (in spite of what many commentators have said). Bonuses were not "guaranteed", and GAR policies did not "guarantee" the same level of bonus as other policies. Equitable's directors had a clear discretion about awarding bonuses. They wanted to give £1,000 to each of the policyholders in my example.

The directors' mistake (which has caused the end of Equitable) was to want to be fair to all policyholders. The mistake is understandable, even commendable. It was not even a mistake until the House of Lords interfered.

The court case

A fact that has gone largely unnoticed is that the court case was not originally about giving different bonuses to GAR policyholders and non-GAR policyholders. The only comment on this in the Court of Appeal (where Equitable lost) was by Lord Justice Waller who said:

• "as between different types of policy it is certainly, in my view, legitimate for the [directors] to have regard to the notional asset share of the different policyholders".

The main argument was about whether the directors could properly give GAR policyholders a special bonus if they did not choose a GAR annuity. The Equitable lost this argument on the bizarre ground that providing the choice:

• "was an exercise of discretion reducing the policyholder's reasonable expectation that he would receive his asset share irrespective of how he exercised his rights under the policy".

I call this "bizarre" because, as my example shows, the whole object of the special bonus was to ensure that each GAR policyholder "would receive his asset share irrespective of how he exercised his rights under the policy". Without the special bonus, GAR policyholders who did not want the GAR annuity (Greg in my example) would inevitably receive less than their fair asset share.

What the House of Lords said

The House of Lords looked at the rules for declaring terminal bonuses and agreed with the directors that they contained "no relevant express restriction on the powers of the directors". They then asked whether a relevant restriction "may be implied".

The legal test for the implication of such a restriction is a standard of "strict necessity". The House of Lords said that it was strictly necessary to imply a restriction because the directors approach was designed to deprive the GARs of any substantial value. This was said after their lordships had acknowledged that no special charge had been made to GAR policyholders for the GARs.

The question about giving different bonuses to GAR and non-GAR policyholders was raised only in the House of Lords, and then only as an after-thought. It was dealt with in a single sentence. Different bonuses were not allowed because "the object would be to eliminate as far as possible any benefit attributable to the inclusion of a GAR in the policy".

Comment

With all due respect to their lordships, their judgment is a nonsense.

The decision ignored legal precedent, defied common-sense and was clearly unfair. Legal precedent says that terms should be implied only where strictly necessary to make sense of the contract. The House of Lords implied a terms simply because they did not like the rules as drafted.

There was always value in the GARs. GARs allowed policyholders to know in advance the minimum level of annuity that could be bought with their guaranteed fund (£700 in my example). If the GARs were intended to provide any level of comfort, it was no more than this.

It was absurd to say that "the object [of giving different bonuses to GAR and non-GAR policyholders] would be to eliminate as far as possible any benefit attributable to the inclusion of a GAR in the policy". It was unfair to imply in this nasty way that the directors' wish to give each policyholder a fair return on their investment must necessarily have had an improper motive.

What about non-GAR policyholders?

The House of Lords did not refer at all to non-GAR policyholders or their expectations. Many non-GAR policyholders started to invest only after Equitable stopped selling GAR policies. They were totally ignored by the courts. They relied on the directors to look after them. They knew nothing of the "implied" term that made it unlawful for the directors to do this.

The House of Lords justified their decision by saying, in effect, that GAR policyholders had "reasonable expectations" that they would get a share of other policyholders' money. The judges did not say, but must necessarily have assumed, that these expectations were more "reasonable" than the non-GAR policyholders' expectations of a fair return on their investment.

All investors in the Equitable with profits fund paid the same premiums and expected the same return on their investment. It was perverse for the judges to "imply" a term that required Equitable's directors to give GAR policyholders a share of the money paid in by other policyholders.

The House of Lords' decision was inevitably going to mean the end of Equitable. Who would invest money knowing that a share would be taken to pay for other policyholders' benefits? It is only right that the Lords' decision should mean the end for Equitable. The judges have made it clear that "equity" (i.e. "fairness") has no role to play. It is wrong to be "equitable".

Should the directors have made reserves?

It may be that Equitable's directors should have made reserves to meet the GAR costs. Had they even suspected the existence of the "implied" term, they would doubtless have done so. However, this would simply have transferred the costs to other policyholders whose benefits would have been reduced to provide the reserves. The money had to come from somewhere, and it is difficult to see why it should not come from the same GAR policyholders who were entitled to the benefit.

In money terms, reserves would have made no difference to the numbers in my example. Money would still end up being taken from Neil and Nigel and given to the other GAR policyholders. The question is simply about how to slice the cake. Keeping a piece for later does not make the cake bigger; the only benefit for Equitable might have been to make the indigestion less acute.

Pension mis-selling

In a mutual insurance company like Equitable, the policyholders own the business. The GAR policyholders were part owners of Equitable when the non-GAR policyholders started to invest. Should the new investors have been warned that part of their money was liable to be taken by these existing owners for their own benefit? Apparently not.

Was the failure to give a warning "pension mis-selling"? It can't have been. In pension mis-selling cases, companies have to pay compensation to the victims and the owners are meant to bear the cost. In the case of Equitable, the House of Lords has told the directors to take money from the victims for the benefit of the owners at the time of the mis-selling (see Note 3).

Can non-GAR policyholders do anything?

It is probably too late. However, they might be able to claim damages for "misrepresentation" (if they were told that they would receive their fair asset share) or "material non-disclosure" (if they were not told that part of their money would be used to benefit other policyholders)>

In my example, Neil and Nigel's loss would be the same as the shortfall in their fair asset share. If their compensation is paid from the with profits fund, none of the policyholders would then get a "bonus", but everyone would have their £1,000 in some form or other. Strangely, this is exactly what the directors wanted to give everyone in the first place!

Conflicts of interest

One difficulty with the Equitable case is due to the lack of balance in newspaper reporting of the matter. Many GAR policyholders have been allowed to express their outrage at the directors' decision to make them pay for their GARs. There has been no comment about who else should pay. Equitable has failed to communicate effectively the reasons for its directors' decisions.

The lack of balance perhaps ought not to be surprising. It may simply be that many newspaper commentators have GAR policies. After all, journalists are not legally obliged to disclose their personal interests in the matters about which they write (even though it may be good practice for them to do so). Judges, of course, are expected not to act in cases where they have a personal interest, even if the interest is not financial (like Lord Hoffmann's interest in the Pinochet case).

In keeping with good practice, I am happy to disclose that I am unusually fortunate as a lawyer in having no investment at all with Equitable. I have two with profits policies with non-mutual insurance companies, of which the smaller has GARs and the larger does not. I do not know whether I am affected for better or worse by the House of Lords judgment. However, I do know a bad judgment when I read it, and this one is dreadful.

Tim Cox

Linklaters & Alliance

Note 1: The figures are over-simplified. In fact the GAR policyholders would get more and Neil and Nigel would get less. This is because every £7 given to the GAR policyholders is worth £10 when applied to a GAR anniuty. The extra £3 must be provided by all policyholders in equalshares, and therefore reduces the amount available for distribution as bonus.

Note 2: In fact both Graham and George may get more, becuase a £ 300 bonus is worth £428 when used to buy a GAR annuity in my example (£ 300 x 10/7 = £ 428).

Note 3: I do not intend to suggest the there was any real mis-selling as such, but it is reasonable to assume that non-GAR policyholders would not have invested with Equitable if they had been warned that part of their investment would go to benefit existing policyholders.