Douglas P. Faucette
I.
Introduction
Insurers that seek to reorganize from mutual to stock form would be
well advised to draw upon the experience gained by the thrift industry as they
consider the corporate restructuring process.
One initiative successfully utilized by thrifts that may be of particular
benefit to insurers lies in the creation of a charitable foundation in
conjunction with a demutualization or mutual holding company (“MHC”)
reorganization. While creating
foundations has proved an integral part of not-for-profit to for-profit
conversions among health insurers, it remains a relatively untested approach in
demutualizations and MHC reorganizations that take place in other areas of the
insurance industry. This article will
discuss the structure of charitable foundations and the advantages they offer
insurers in connection with a corporate reorganization.
II.
Structure, Process and Obligations
A corporate foundation is a private foundation that is funded by a
sponsoring corporation. It may be funded
with cash, common stock or other property.
The foundation is a separate legal entity from the sponsoring
corporation, although the corporate foundation may be closely tied to the
sponsoring corporation through an interlocking board of directors and staff.
In the past several years, a number of mutual savings institutions
have formed charitable foundations in connection with corporate
reorganizations. They have funded these
foundations with common stock issued in the stock offering as part of the
conversion. Such foundations may be
established as non-stock corporations under state law or as trusts, and must
apply for tax-exempt status at both the state and federal levels. Contributions to the charitable foundation
are tax deductible for federal income tax purposes over a six-year period with
deductions generally limited to ten percent of taxable income in any one year.
Although the circumstances vary with each institution, under the
Internal Revenue Code (the "Code") and implementing regulations, a
charitable foundation must be organized and operated exclusively for
charitable, scientific, literary or educational purposes. The assets of a private foundation must not
inure to the benefit of a private individual, nor may the foundation engage in
lobbying or political campaigning of any kind.
At the same time, self-dealing rules set forth in the Code prohibit a
foundation from transferring income or assets to disqualified persons such as
the sponsoring corporation and managers and directors of the foundation. Violating the rules applicable to private
foundations, including the self-dealing rules, subjects both the foundation and
disqualified persons to substantial excise taxes.
Finally, the insurer must satisfy any relevant state insurance laws
governing affiliate transactions. For
example, insurers within a holding company system must ensure that any
transaction meets certain levels of reasonableness and fairness. Creating a charitable foundation in
conjunction with a corporate reorganization would also likely require prior
notification of the state insurance commissioner.
III.
The Advantages of a Foundation to a
Demutualizing/Reorganizing Insurer
For insurers there are a number of advantages, both financial and
altruistic, that can be gained by establishing a charitable foundation in
conjunction with a demutualization or an MHC reorganization. First, a foundation increases the name
recognition of the insurer, providing the insurer with a vital competitive
edge. Second, it may help establish a
means to fund a consistent level of charitable giving despite future downturns
in corporate profitability. Third,
contributing funds to a foundation allows the insurer to receive a tax
deduction for the contribution and to have the earnings on the contributed
assets taxed at a rate that is much lower than the insurer’s corporate tax
rate. Fourth, creating a foundation
makes for more efficient corporate management by allowing the board of
directors to limit the effects of shareholder apathy with respect to voting.
Creating a foundation is likely to increase public awareness of the
converting insurer and thus improve customer ties. In this regard, a foundation would
potentially enhance the insurer's reputation for community service and increase
its public exposure. For example, John
Hancock Financial Services, Inc., which is headquartered in Boston, has gained
considerable good publicity from its HEART program (Hancock Endowment for
Academics, Recreation and Teaching).
Since 1985, John Hancock has provided nearly $1 million to financially
strapped schools in the Boston area. For
a converting mid-sized mutual insurer that lacks the name recognition of John
Hancock, the added publicity and goodwill a foundation provides could be a
great benefit.
A second related benefit for insurers in establishing a corporate
foundation is that it provides a unique opportunity to fund the foundation with
a significant endowment, either in the form of cash or common stock. Funding a foundation with the insurer’s
common stock is a means of allowing the foundation to share in the growth and
success of the insurer over the long term and can thereby enhance its
value. A foundation also permits the
insurer to better coordinate its philanthropy by establishing uniform policies
with respect to corporate giving. While
the amount of the contribution to the foundation would be expensed in the
quarter in which the contribution is made, there is likely to be little, if
any, negative effect on the insurer's capital since the insurer will be raising
new capital in the demutualization or reorganization.
In addition, there would likely be no negative impact on income
going forward. Funding a foundation with
common stock has the potential to provide the foundation with a larger
endowment than if the insurer contributed cash because stock-based funding
carries the potential for both appreciation and dividend payments. As a result, a contribution of stock has the
potential to provide a self-sustaining funding mechanism that can reduce the
amount of cash the stock company would have to contribute to the foundation in
future years to maintain a level amount of donations.
Furthermore, the funds placed in a charitable foundation receive
more favorable tax treatment than if they are retained by the insurer and given
directly to charitable organizations.
The insurer receives a tax deduction for the contribution that it can
utilize over a six-year period. In
addition, the insurer is not taxed at its corporate rate on the earnings of the
contributed assets. Instead, these
earnings will be taxed at the foundation level at a rate of two percent.
Finally, donating shares of common stock to the foundation places a
block of shares in friendly hands and helps ensure that enough votes will be
cast on matters requiring shareholder approval.
For example, under Delaware law, if management cannot achieve a majority
of outstanding shares, a corporation cannot engage in mergers or make
acquisitions -- two of the primary benefits of reorganizing to stock form in
the first place. With a charitable
foundation, management can be assured that a significant block of the
outstanding shares will be voted. This
advantage should not be confused, however, with entrenching management. Although insurance regulators have yet to
address this issue at great length in the context of a demutualization or MHC
reorganization, regulators in the thrift context have generally imposed a
condition on such transactions that prevents foundations from serving as tools
for corporate control. These rules
mandate that the foundation must vote the foundation's shares in the same
proportion as votes cast by the other outstanding shares. Thus, the foundation merely helps to ensure
that sufficient votes are cast in consideration of a proposal; it does not assure
the vote’s outcome.
Of course, creating a charitable foundation is not without
drawbacks. The time and cost of dealing
with the legal, reporting and compliance requirements for private foundations
are not factors to be dismissed lightly, nor is the fact that private
foundations are subject to stricter requirements than public charities. In addition, while the contribution is tax
deductible, it could also have an adverse impact on earnings per share. These concerns are matters that a
reorganizing insurer must carefully weigh in deciding whether to form a
foundation.
IV.
Conclusion
While federal and state banking authorities have imposed several
regulatory conditions on establishing and funding charitable foundations in
connection with conversions and reorganizations in the thrift industry, it is
unclear how state insurance regulators will respond to this novel approach to
demutualizations and MHC reorganizations in the insurance industry. If the treatment afforded thrifts is any
indication of state insurance regulators' willingness to accept the creation of
charitable foundations in an insurance context, then the chances of success for
insurers in this area are very promising indeed.
(Author's bio)
Douglas P. Faucette is a senior partner in the Washington, D.C. law
firm of Muldoon Murphy & Faucette LLP.
His practice involves the representation of financial institutions
before federal and state financial regulatory agencies. The author wishes to
thank Roy E. Brownell II who assisted in the preparation of this article.