*Formatting of these documents may vary from those filed with the Division of Insurance due to the conversion process to make them available through the web.

COMMONWEALTH OF MASSACHUSETTS

DIVISION OF INSURANCE

_______________________
Plan of Reorganization of    )
John Hancock Mutual Life )                                                                                       Docket No. F99-04
Insurance Company             )
_______________________)

Introduction

My name is David Schiff. I am the editor and writer of Schiff’s Insurance Observer, an independent newsletter that provides analysis and commentary on the insurance industry.

My testimony will do the following: (1) outline my background and qualifications; (2) discuss why the Hancock’s Plan of Reorganization ("Plan") is unfair and prejudicial to its policyholders, including how: (A) the Policyholder Information Statement ("PIS") is deceptive, misleading, and coercive to policyholders; (B) the Plan’s approval process and vote is flawed, due, in part, to the fact that Hancock has "lost" nearly 400,000 (14%) of its eligible policyholders; (C) the Plan’s method for distributing stock to policyholders and selling stock to investors is unfair and prejudicial to policyholders. I also concur with the opinion of James Hunt that the allocation of consideration is not fair and reasonable to policyholders.

Qualifications

Before I briefly describe my qualifications, I want to say that I am not available to testify as an "expert witness" in the traditional manner, which is that of a person who is available for hire and is paid in exchange for his testimony or opinions. I do, however, often testify and participate in matters of importance regarding the insurance industry on a pro bono basis.

I am president of Schiff Publishing, Inc., and serve as the editor and writer of Schiff’s Insurance Observer (which I started in 1989), a widely read newsletter that provides in-depth analyses and commentary on the industry, as well as commentary and analysis regarding corporate finance, capital transactions, and corporate-governance matters relating to the insurance industry.

I began working full time in the insurance industry in 1977, and subsequently worked in the investment, investment banking, and corporate finance fields. I have owned and run a successful insurance brokerage, which was sold in 1997.

As part of my work for Schiff’s Insurance Observer, I spend a substantial amount of my time analyzing insurance-company financial reports and other documents, and frequently meet and talk to senior management of major domestic insurance companies and insurance brokerages, as well as insurance analysts, investment bankers, rating agencies, regulators, institutional investors, and insurance buyers.

I am also intimately familiar with the mutual industry and, in particular, with the corporate governance of mutual insurance companies, as well as various forms of demutualizations. I have written and spoken extensively on the subject and have been a dissident nominee for the board of Allied Mutual. (Although I was not elected to Allied’s board, as a result of my work, Allied Mutual unwound insurance-pooling contracts that had been detrimental to policyholders, and ultimately returned $110 million to policyholders in the form of a special dividend.) I have participated to varying degrees in numerous mutual insurance company proceedings, including those involving Principal Mutual, FCCI Mutual, Provident Mutual, Security Benefit Life, Ohio National, Nationwide Mutual, Millers Mutual, Allied Mutual and MONY, among others. I have also participated in a variety of public hearings, NAIC meetings regarding mutual insurance companies, and state legislative hearings. I do not accept any compensation (contingent or otherwise) for this work, nor do I accept any reimbursement for my personal expenses.

I frequently speak or lecture before various national insurance-industry groups and associations, and have also spoken at events hosted by investment-banking, and research firms, as well. In those instances where travel is involved, I accept reimbursement for my out of pocket expenses.

In addition to the foregoing, I have, over the years, served as a director of six private companies in a variety of industries.

I am well qualified to opine as an expert on the reorganization of John Hancock. As an independent industry analyst and observer who is not being paid, I have no particular financial interest that might influence my testimony, and I have no expectation or reasonable likelihood of financial gain as a result of my testimony.

Documents Reviewed

I have reviewed various John Hancock documents, including financial statements and other data including but not limited to material sent to policyholders in connection with the reorganization, testimony submitted by Hancock, and various memoranda in the public record.

Assessment of the Plan

In my view, the Plan is unfair and prejudicial to John Hancock’s eligible policyholders—including the four Participants to these proceedings. I will testify as to different aspects of the Plan and describe briefly why it prejudices the policyholders. I will also provide alternatives that could make the Plan fair, and not prejudice the interests of policyholders or the insuring public.

A. The Policyholder Information Statement is Misleading

The Policyholder Information Statement and Information Guide (generally "PIS") are coercive, deceptive, and misleading in numerous ways.

Although policyholders are being asked to vote to extinguish their "membership interests," the Plan does not fully inform them what these vital interests entail. For example, the Information Guide, which is likely to be the most widely read document of the PIS, contains a page (page 5) titled "Answers to your questions about the conversion plan" which states:

What "membership interests" will I be giving up?

Membership interests primarily consist of the right to vote at John Hancock’s annual policyholders’ meeting, and the right to share in John Hancock’s residual value, if any, in the unlikely event of a voluntary liquidation of John Hancock.

This limited "membership interest" definition is repeated throughout the PIS and Plan. For example, on page 1 of the PIS Part 1, it states:

"In a mutual company, there are no stockholders. Instead, policyholders or insureds have membership rights which include the right to vote at John Hancock’s annual meetings."

This is repeated again on page 16 of the PIS Part 1 under "Factors To Consider When Voting":

If the Plan goes into effect, policyholders will give up membership interests in John Hancock. These include the right to vote at annual meetings and the right to share in any residual value of John Hancock in the unlikely event it were to undergo a voluntary liquidation some time in the future. Of course, policyholders will not give up their policies, and policy benefits, values, guarantees and dividend rights will not be reduced whether or not the Plan is approved."

This definition was further employed by Hancock in scripts for policyholders who telephoned with questions. For example, the script in use on and before February 11, 1999 (which is contained in Participants’ Exhibits) stated:

Caller: What are my membership rights?

Customer Service Rep: Your membership rights primarily consist of the right to vote in the election of directors and the right to share in the liquidation of the company.

The definition in the actual Plan, should policyholders read that far, is consistent with these statements.

Yet Hancock relies on substantively different definitions of policyholders’ membership interests when it is expeditious to do so. For example, Hancock relies on its legal advisors at Debevoise & Plimpton, who rely on Internal Revenue Service rulings and state law in a May 12, 1999 "Memorandum to the Files: John Hancock Mutual Life Insurance Company Memorandum in Support of Tax Opinions" for the following propositions. On page 2 of the Memorandum, it states:

"…policyholders of a mutual insurance company have a dual legal relationship to the company: as members of a membership corporation they have proprietary interests in the company which are treated like corporate stock for federal income tax purposes, and as policyholders they possess the contractual rights provided for in their insurance contracts."

On page 3, the Memorandum continues:

"The treatment of policyholders ‘ proprietary interests in the mutual as the equivalent of stock ownership is based [sic] sections… of the [Internal Revenue] Code…"

(Emphasis added.) Importantly, the Memorandum further states at the bottom of page 3 that Debevoise & Plimpton believes Massachusetts law is consistent with other relevant authorities that "the policyholders’ membership rights are interests in the nature of corporate equity ownership and are not merely contractual rights under the policy." Other references to policyholders’ "equity interests" are repeated elsewhere in the Hancock Memorandum.

Thus, while Hancock recognizes and admits that participating policyholders’ membership interests are "proprietary interests" and the equivalent of "corporate equity ownership" [common stock] in internal documents, it misleads its voting policyholders by influencing them to believe that their membership interests are merely voting rights and unlikely-to-be-received liquidation distributions. Chairman and CEO Brown submitted testimony stating that "[a] Participating Policy is a policy that is eligible to participate in the divisible surplus of John Hancock, whether or not policy dividends are actually paid." (Written Statement of Stephen L. Brown at page 10.) In contrast, non-participating policies such as those issued by John Hancock Variable Life (a stock subsidiary of Hancock) might receive contractually provided dividends, but would have no right to Hancock’s divisible surplus. Brown’s statement is consistent with a private letter ruling by the IRS—cited in Hancock’s May 12, 1999 Memorandum at page 1—that discusses "membership interests," which states, in important part:

"… the policyholders of Mutual, through the purchase of participating insurance policies, acquire both insurance coverage and certain rights ("membership interests") in Mutual. Among those rights are the right to vote and the right, under law, to receive distributions of surplus (other than any contractual rights to policyholder dividends.)"

(Emphasis added.) Hancock should have informed its voting policyholders of this important proprietary right to distributions of surplus (which is above and beyond dividends paid on the policy as a contract) in the PIS, Information Guide and on the telephone. Hancock’s failure to do so misled policyholders because most of them would not know—or be able to infer—what they would be exchanging under the definition of "membership interests" when voting on the Plan. Furthermore, by leaving out material information, Hancock encouraged its policyholders to vote and act in a manner that was generally contrary to their (the policyholders’) interests.

Let me elaborate: par policyholders are receiving consideration for the termination of their proprietary rights in Hancock’s "equity" (e.g. dividends, distributions, etc., as well as the right to have the company run for their benefit). Policyholders’ interests in the Closed Block will be purely contractual, including dividend payments. The financial harm to policyholders who are cashed out (e.g. those who do not "exchange" their membership interest for stock) is that they will no longer have a proprietary [equity] interest in their insurer. This propriety equity value is significant, and Hancock believes that it will increase over time in the years following the reorganization. As discussed further below, approximately 80% of Hancock’s policyholders will have traded away their equity interests without understanding the ramifications of what they were doing, because the ramifications were not properly delineated in the material sent to policyholders, and because even those policyholders who were able to read through the material they received, were given an incomplete—and therefore misleading—portrayal of what was taking place.

In the Plan, Hancock should have informed policyholders of their equity interests, the nature of those interests, and set the default to stock so as to ensure informed consent in a cash-out decision. The default to cash is not only prejudicial, it is inherently unfair and carries negative tax consequences. It is cruelly ironic that Hancock’s Plan calls for unsophisticated policyholders to have to make a complicated decision about an important financial asset by November 30, 1998, whereas "sophisticated" (to use Mr. Kirkland’s term) institutional investors will not have to make any decision at all until much later, and will, additionally, have had the benefit of a "road show" and other information not generally available to policyholders—before they make any decision. To make matters worse, policyholders who must choose to elect stock by November 30, 1999, will not even have the benefit of selling their stock in the public market on a favorable short-term basis (should that situation arise out of the offering) because they will not receive their shares until approximately seven weeks after the effective date of the Plan.

This situation is particularly egregious in light of the statement by Morgan Stanley’s Mr. Kirkland’s that "a Hancock policy" may be small policyholders’ "sole financial asset." The default to cash aspect of the Plan creates a situation that is immediately taxable to policyholders who are not sophisticated enough to elect stock (and who can avoid all taxes if they hold their stock). Furthermore, a policyholder who wants to sell his stock, could hold it long enough to receive the generally favorable tax treatment accorded a long-term capital gain. The Plan is prejudicial for these reasons alone.

The Plan fails to disclose the future ownership of Hancock

The Plan and PIS fail to inform policyholders that Hancock expects to cash out the majority of its current policyholders, leaving approximately 70% of stock ownership in the converted stock company in the hands of approximately 20% of current policyholders. Immediately after the completion of the offering, approximately 30% of stock would be owned by institutional investors in the IPO. (See PIS Part 2 at pages 27, 54-55.) Because Hancock intends to cash-out policyholders with less than 65 shares, the majority of shares will be owned by policyholders outside of the Closed Block. It is these policyholders who will stand to benefit from appreciation in stock value after the IPO, and these policyholders (as shareholders)—and shareholders who are not policyholders—for whom the company will be run in the future. Had most current policyholders fully understood this situation, it is unlikely that they would choose cash or the default-to-cash. They would further be influenced by the fact that their (the policyholders’) future dividends will be limited to the performance of the Closed Block (which will have greater liabilities than assets—the exact amount has yet to be disclosed) as opposed to Hancock’s current balance sheet, which has greater assets than liabilities, and which policyholders may now share profits from.

Management and Board Stock Ownership

The Plan fails to indicate whether Hancock’s board and managers will elect to receive stock or elect to be cashed out. Upon belief, most Hancock senior management and board members will receive stock, and in instances where they have a choice, will choose to receive stock. Their decision should have been disclosed to policyholders in the PIS and Information Guide.

Morgan Stanley’s Fairness Opinion is Fatally Flawed and Misleading

The "fairness opinion" attached to the Plan (PIS, Part 2, at page A-11 to 16) is unfair because Morgan Stanley has conflicts of interest that make it unfit to provide a fairness opinion. Morgan will be the lead underwriter in the Hancock IPO and, thus, has a substantial financial interest in the Plan being approved. This conflict of interest alone demands a similar result to what occurred with Goldman Sachs’ fairness opinion rendered in conjunction with the reorganization of Principal Mutual in Iowa. [See Participants’ Exhibits for Iowa Commissioner’s Order.] However, since the full extent of Morgan Stanley’s substantial conflicts of interest have not been disclosed to policyholders in the PIS and Information Guide—Goldman provided greater disclosure in the Principal’s PIS)—the Hancock Plan misleads policyholders who considered the Plan and can reasonably be believed to have relied on Morgan Stanley’s fairness opinion. (Morgan Stanley’s Derek Kirkland used a similar approach in Provident Mutual’s attempt to reorganize as a mutual holding company this year. I opposed the Provident Plan at a Pennsylvania regulatory proceeding.) In the Provident matter, several policyholders sued and obtained a permanent injunction blocking the reorganization on the grounds that the policyholders had been misled by the PIS. In ruling, the court said, among other things, that it would require Provident "to disclose the compensation and contingency arrangement it has with Morgan Stanley." (See Butler et al. v Provident Mutual Life Ins. Co., Pennsylvania Ct. of Common Pleas, Civ. No. 9901-0780 (1999).

Furthermore, Morgan does not compare the Plan to various alternative forms of reorganization that might yield greater value to policyholders. It has not provided an appraisal of what the company might be sold to a third party for. If policyholders were aware that Hancock could be sold to a third party for a higher price it would undoubtedly affect their decision to receive stock or cash. That this material comparison is not included renders the fairness opinion moot. An opinion cannot be made in a vacuum—all reasonable alternatives must be considered and communicated to policyholders. While the board might choose to reject certain alternatives that might yield higher value, it has a duty to present those alternatives to policyholders so that they can make an informed decision. Without informed consent, the policyholders’ vote must be considered void.

The Hancock Plan’s material nondisclosures of Morgan Stanley’s irreconcilable conflicts is misleading and coercive and warrants rejection of the current Plan. The Hancock Plan’s material nondisclosures of Morgan Stanley’s failure to consider those alternatives and present them to policyholders, is misleading and coercive and warrants rejection of the current Plan

In conclusion on the Plan and PIS, any one of the above disclosure problems would lead a significant number of policyholders to vote in favor of the Plan (and to allow themselves to be cashed out). Had they received full and fair disclosure it is likely that they would have voted in a different manner and/or elected to take stock. Since Hancock’s policyholders must vote on the Plan and since the vast majority will cast their votes by mail for or against the Plan based exclusively on the PIS and Guide (and other information provided exclusively by Hancock), Participants and their fellow policyholders are prejudiced by the materials. The legally required policyholder vote will be invalid and should be rejected by the Commissioner as it was by the court in the Provident Mutual matter.

Executive Compensation

As stated in Participants Petition to Intervene, the disclosures on executive compensation to New York State versus the PIS are different for senior management. This matter must be reconciled for the record as does their intentions regarding stock options.

Alternative Proposal

Policyholders who don’t elect cash could receive their shares through a special purpose closed-end fund or open-ended mutual fund. This would provide a tax-efficient means for policyholders to receive value and would provide them with almost immediate liquidity should they so choose. This mutual fund could be run by independent managers, and would serve several purposes: 1) Hancock would not have the expense of many small policyholders, 2) Policyholders would not have to be cashed out and the underwriting expenses of approximately $100 million could be eliminated, 3) the fund could be managed by institutional investors. (Hancock seems to believe that institutional investors are important to its success, although I disagree with this. One need look no farther than Berkshire Hathaway to realize that it is not institutional shareholders that make a company successful, but good management that makes a company successful.)

The Plans Approval Process and Vote is Flawed

Hancock has revealed in the record, but not to its policyholders in the PIS, that it has lost nearly 400,000 policyholders, mostly WPO policies that are small and were sold to working class policyholders. This amounts to approximately 14% of its total voting policyholders, is a number that far surpasses the number of votes cast in Hancock’s annual meetings over the last 50 years combined, and will near the predictable vote by an estimated 20 to 25 percent of policyholders on this reorganization upon which Hancock will proclaim a mandate to demutualize. The enormous number of policyholders lost, and the resulting financial loss to them of at least $130 million dollars in fixed consideration (assuming a $20 share value) combined, renders this process prejudicial to Hancock’s policyholders entitled to a valid vote and a fair Plan. Of course, the state has a conflict of interest here to the extent those lost monies will revert to the state in which the policyholders last resided before Hancock lost them.

 

C. The Plan’s method for Distributing Stock is Prejudicial to Policyholders The Initial Public Offering is Prejudicial to Policyholders

 

Hancock does not need the proceeds of the offering, most of which will be used to buy out 80% of its policyholders.

Furthermore, the unprecedented default-to-cash harms the 80% of policyholders who lose equity their interests without adequate disclosure. It is also expected that the Initial Public Offering ("IPO") will dilute policyholders’ interests in the sense that shares will be sold at a price below the company’s "Private Market Value." (If sophisticated institutions did not believe this, they probably wouldn’t buy the offering.) Also, the 120% cap is prejudicial to policyholders interests; and the Plan’s denial of policyholders subscription rights is prejudicial.

The conditions listed in the paragraph above benefit sophisticated institutional investors and harm unsophisticated policyholders who are cashed out or who are unable to buy on the offering and avoid economic dilution.

For the foregoing reasons, the Plan as constituted must be rejected by the Commissioner because it is prejudicial to policyholders.

David Schiff

 

November 8, 1999