Mutuals could begin raising capital by issuing deferred shares from next year if outstanding issues are resolved, says expert

The Mutuals' Deferred Shares Act, which received Royal Assent in March 2015, seeks to address these challenges by giving mutual insurers the option of raising regulatory capital in the form of deferred sharesto meet minimum capital requirements or to fund future expansion without losing their mutual status.

The UK Treasury recently published draft regulations for consultation, while a Financial Conduct Authority (FCA) consultation on the marketing and administration of mutual deferred shares closes on 2 November 2016.

Although the Treasury's consultation paper is a useful starting point, the draft regulations leave a number of issues to be resolved before they can be used by mutuals to raise capital in this way:

• the corporation tax treatment of mutuals raising capital with deferred shares remains unclear;
• there could be substantial delay to obtaining the regulators' consent;
• a requirement to undertake a segregation of funds before issuing such shares, which applies only to with-profits mutuals, imposes a further layer of complexity and cost to the process;
• the process will involve significant costs and is likely to be affordable by only the very largest mutual, thereby disincentivising many smaller mutuals from embarking on the process;
• the heavy cost will have to be weighed up against the potential for a material adverse effect on the interests of with-profits policyholders and a breach of the FCA's Conduct of Business rules.

The idea to allow mutual insurers an opportunity to raise capital externally, rather than doing so just by retaining profits, is a good one and has been successfully championed by the mutual insurance industry for some time. However, in practical terms it will only really be available to the largest mutuals and, even then, there would need to be a greater degree of certainty than now if any are going to attempt the process.

The Treasury estimates that up to 10 societies may issue deferred shares in the next few years.

The FCA expects issuance sizes of approximately £70m - £100m.

Hopefully, there will be sufficient time and attention given by the Treasury and FCA in the next few months to enable clarity to be achieved by the end of this year. This would allow some mutuals to initiate projects to issue deferred shares in 2017, allowing them to fund growth and acquisitions in the future and keep the mutual insurance business model, that many cherish and trust, alive and kicking.

The background

"Friendly societies and mutual insurers have existed in the UK for hundreds of years. Their origins lie in community networks, where a group of people contributed to a mutual fund that could support them at a time of need", as the Treasury's recent consultation paper put it.

Mutuals are owned by their members and operate some form of democratic voting system. This distinguishes them from shareholder-owned companies, where customers and owners are distinct and votes are distributed according to capital ownership.

Insurance mutuals were not designed with capital markets investors in mind, and today's mutuals operate in a market which is very different to that of their predecessors. Shareholder-owned companies are now the norm, and external capital-raising is often an essential component of insurers' growth and investment.

Like all businesses, mutuals are able to borrow against future earnings if they wish to raise additional funds. However, they are unable to issue shares, which prevents them from accessing a much wider pool of long-term capital via the equity markets. This means the mutuals' flexibility to respond to new market conditions is constrained.

The 2015 Act

The Mutuals' Deferred Shares Act sought to address the lack of access to external capital by legislating for mutual insurers to be able to issue a new type of capital instrument: deferred shares.

The Act is split into two main sections. The first gives the Treasury the power to make regulations which permit the issue of mutual deferred shares by a friendly society or mutual insurer. Prior consent of the relevant regulators must be obtained before they are able to do so. It also gives the Treasury powers to specify further characteristics of mutual deferred shares, noting that these are not the same as shares within the meaning of the Companies Act 2006.

The second section is aimed at preserving some of the key characteristics of mutuals despite their new ability to issue mutual deferred shares. Mutuals will be able to provide membership rights to shareholders, but will not be able to grant more than one vote per shareholder member and no shareholder member will receive more votes than a non-shareholder member by virtue of being a shareholder member. In addition, shareholder members will not be permitted to vote on certain processes which might result in demutualisation.

The Treasury consultation

Published in August 2016, the Treasury consultation included draft regulations to define the characteristics of mutual deferred shares. The Treasury worked closely with representatives from the mutual industry and regulators to discuss the detailed processes for issuing deferred shares, how to ensure compliance with regulatory requirements and how to balance the interests of shareholder members and non-shareholder members.

The draft regulations aimed to provide a basic level of clarity and consistency regarding the characteristics of mutual deferred shares in order to support the development of a coherent market. It will be for mutuals themselves to determine the detailed terms and conditions of individual share issues.

The main proposals governing deferred shares are that:

• mutual society shares will be perpetual instruments;
• income payments will be discretionary and, to avoid causing problems for with-profits policyholders, the money that may be distributed as income will be limited to the firm's accumulated, realised profits (where not previously used for distribution or capitalisation); less its accumulated, realised losses (where not previously written off in a reduction or reorganisation of capital);
• investors will not have the usual rights of holders of company shares, such as voting in proportion to shareholding; and
• societies will be able to choose whether to issue ordinary or preference shares and, if they issue preference shares, to comply with Solvency II the shares must include provision for a write-down mechanism that imposes losses on the shareholders in the event of the mutual breaching the relevant regulatory triggers on capital adequacy.

The consultation closed on 30 September 2016. The Treasury expects to finalise the regulations and publish a statement of its conclusions before laying the regulations before Parliament for its approval before the end of 2016.

The FCA consultation

Proposals applicable to mutual deferred shares were included in the FCA's Quarterly Consultation Paper No.14 (CP16/21), published in September 2016.

The FCA is concerned that deferred shares will be relatively unusual, complex and risky for many ordinary retail investors. They are also likely to be relatively illiquid and pose a risk of inappropriate distribution to non-sophisticated investors. It is therefore proposing additional requirements for firms that wish to promote the shares to ordinary retail clients so that consumers who decide to invest in mutual society shares have at least a basic awareness of the risks involved and only invest money they can afford to lose.

Distribution is expected to be via self-placement, where societies sell the shares to their own members; and via third-party intermediaries specialising in advisory or portfolio management services.

The FCA's proposed rules will permit distribution of mutual society shares to professional and eligible counterparty clients without restriction. They will also permit distribution to retail investors classed as certified sophisticated investors, self-certified sophisticated investors and certified high net worth investors.

For ordinary retail clients, the rules will permit distribution where the firm provides specific risk warnings, including the warning that investing more than 10% of the client's net investable assets in this type of instrument is unlikely to be in their best interests. To demonstrate that these risk warnings have been read and understood, the rules will require that firms obtain written confirmation from clients, including an undertaking to limit their investment in mutual society shares to no more than 10% of their net investable assets. Firms are not expected to take responsibility for assessing whether or not clients make good on this commitment.

The MiFID appropriateness test is also applied to non-advised sales as a further safeguard. Firms carrying on non-advised sales of mutual society shares outside of MiFID scope need to satisfy themselves that the retail investor is likely to have the requisite experience and knowledge to understand the risks involved for investment in mutual society shares. This requirement applies where that same transaction would be subject to the appropriateness test if it was MiFID or equivalent third country business. Where a firm carrying on MiFID or equivalent third country business would not need to apply the appropriateness test, firms carrying on non-MiFID business do not need to conduct it either.

The consultation proposes that firms be required to keep a record demonstrating compliance with these requirements on the sale of mutual society shares to retail investors. Such recordkeeping responsibility may be delegated by the person allocated the compliance oversight function in each firm, provided they have reviewed and approved the process for certification of compliance no more than 12 months before the date of the deal.

The FCA's consultation closes on 2 November 2016, and the FCA intends that these rule changes will be implemented by the time the shares may be issued.

Bruno Geiringer is an insurance law expert at Pinsent Masons, the law firm behind Out-Law.com.