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Policyholders Challenge Practice of Dividends Declaration From Company Surplus

The Michigan Court of Appeals ruled last week against a class of policyholders that brought an action seeking to compel a distribution of the surplus of a mutual insurance company. Even though the decision may be appealed, this is clearly a victory for mutual insurance companies.

In its decision, the court wrote: "While the purpose of a business corporation is to distribute profits to its shareholders, the purpose of a mutual insurance company is to provide affordable coverage to its members".

The case is similar to other actions brought in California (Hill v. State Farm) and Texas (State Farm v. Lopez on appeal) to compel distributions of surplus in similar actions.

NAMIC has been actively involved in the Michigan and California cases, filing amicus curiae (friend of the court) briefs in each. This process enables entities with relevant knowledge to participate in the proceedings by providing factual and persuasive information that addresses issues important to our member companies.

Hill v. State Farm
Churella v. Pioneer State Mutual
State Farm v. Lopez

Hill v. State Farm

California

Hill v. State Farm is a California case involving a class action brought by past and present policyholders seeking a distribution of surplus from State Farm. In this case however, the class is not confined to the policyholders of the state of California, but to a nationwide class of plaintiffs. The suit was filed in 1999 and claims a breach of duty by State Farm's board of directors for failing to declare policyholder dividends out of the company's "excess surplus" for approximately 50 million members of the class. The plaintiffs contend that State Farm accumulated surplus beyond that which is "reasonably and prudently" necessary to run the company and seek to compel the company to distribute as much as $47 billion in "excess surplus" to class members. Of the approximately 50 million policyholders included in the class, 45 million (90 percent) reportedly neither reside in, nor have any contact with, the State of California.

The current appeal is from a Los Angeles Superior Court decision that framed the issue as a determination of whether Illinois corporation law or California contract law governs the resolution of the case. It ruled that California contract law would apply, because, in its own words ".[o]therwise, insurers could employ corporate governance rules and abuse of discretion standards to avoid contractually enforceable promises to exercise discretion in a manner that, in good faith, considers policyholder's dividend interests." State Farm has appealed this decision by the trial court and was joined in support of its appeal in full briefs filed by NAMIC and by the National Association of Insurance Commissioners.

In essence, the plaintiffs claim that the issue is one of contract law, including the implied duty of good faith and fair dealing. The contract provision on which the plaintiffs base their claim is the provision in the State Farm insurance policy, found in a section entitled "Mutual Conditions", describing their rights as members of the mutual company.

Membership.

While this policy is in force, the first insured named in the declarations is entitled to vote at all the meetings of members and to receive dividends the Board of Directors in its discretion may declare.

Plaintiff's alleged in their lawsuit that this admittedly discretionary provision of the insurance policy should be subject to an implied duty of good faith and fair dealing on the part of State Farm in exercising its discretion. The trial court agreed with this line of argument and stated in its decision.

The State Farm insurance policy, though it expressly provides that dividend declarations are discretionary, does not expressly waive the implied duty of good faith and fair dealing. As such, State Farm, in exercising its discretion, has an obligation to consider fairly and in good faith the objective, contractually enforceable expectations of its policyholders, including their dividend interests.

In pursuing its appeal State Farm has continued to argue, as it did in the lower court, that:

1) the "internal affairs doctrine" applies to this issue and the corporation law of Illinois is the appropriate law to apply to this case. The decision to declare or not to declare dividends is a matter of company governance and financial management - not contract law.

2) Illinois should be the appropriate forum and law to resolve this action since to do otherwise is to ask State Farm to potentially respond to 50 different jurisdictions on matters related to the internal governance and financial affairs of the company.

3) Since Illinois is the state of primary regulatory oversight, including solvency regulation, it's law should apply since it will be required to deal with the potential negative consequences of a decision that may have a significant effect on the company's financial operation and stability.

In its appeal State Farm has been supported by amicus briefs filed by NAMIC, the NAIC, and a letter filed by other insurance trade associations. The briefs have stressed, in varying degrees of detail, the differences between mutual companies and stock companies in respect to surplus accumulation and dividends. The briefs have also provided the court with explanations of the "ownership" interests of policyholders of mutual insurance companies. All the briefs filed have urged the court to apply the corporation law of the State of Illinois to the case in light of the regulatory and mutual company internal governance issues the plaintiff's action present.

If the Court of Appeals rejects State Farm's appeal the case would then likely go to trial in the Los Angeles Superior Court.

Update: Legal Standard for Mutual Company Dividend Decisions Upheld

A California Court of Appeals ruled that policyholders of mutual companies cannot compel directors to declare dividends unless they can provide evidence that the board failed to declare dividends due to fraud, oppression, dishonesty, illegality or lack of informed and independent decision making. The decision is favorable for State Farm, and entitles mutual insurance companies and their boards to the protection of the business judgment rule on decisions affecting dividends and other internal governance practices. More...

Court Documents

Original Complaint in Hill Vs. State Farm

California Court of Appeals writ of mandate directing the trial court to apply Illinois law to the claims at issue

State Farm Motion to Determine Law and to Dismiss

Plaintiff Class Response

State Farm Reply to Plaintiff Class Response

Court Decision re State Farm motion

Briefs

NAMIC Brief of appeal from Court Decision

Letter Brief of Joint Trades; Brief of American Council of Life Insurers; Brief of Illinois Department of Insurance; Brief of National Conference of Insurance Legislators

Brief of Citizens For A Sound Economy Foundation (CSE)

Churella v. Pioneer State Mutual

The Michigan Court of Appeals has just ruled against a class of policyholders that brought an action seeking to compel a distribution of the surplus of a mutual insurance company. The case is very similar to other actions being brought in California (Hill v. State Farm) and Texas (State Farm v. Lopez) to compel distributions of surplus in similar actions. NAMIC has been very involved in each of these cases, filing amicus briefs in each lawsuit to cover issues that are important to the consideration of these actions.

In the Pioneer case, the plaintiffs claimed that Pioneer held surplus assets that exceeded their reserve requirements and that the company was obligated to distribute this surplus to them in the form of dividends. As part of its claim, plaintiffs argued that mutual company policyholders had the same rights as shareholders of a stock company and that the business judgment rule did not apply to the board's failure to approve dividends.

Pioneer defended against the action by insisting that the plaintiff policyholders had no cause of action and that the court did not have jurisdiction over the subject matter of the lawsuit. The Michigan Attorney General (AG) and Insurance Commissioner (Commissioner) intervened in the case and also sought dismissal for the same reasons as Pioneer - alleging specifically that the Commissioner held exclusive jurisdiction of the matter. While NAMIC was not allowed to intervene, it was allowed to submit briefs instead.

The case has had an interesting procedural history that has already included one trip to the Michigan Supreme Court (where it might be headed again). When brought nearly 2 years ago it was dismissed because both the trial court and the appeals court held that the Commissioner had exclusive jurisdiction over the case. The Michigan Supreme Court disagreed, and sent the case back to ask that the trial court address challenges to the action that did not depend on jurisdiction issues. The trial court then granted the defendants motion to dismiss on the grounds that the lawsuit failed to state a claim recognized by law. Plaintiff's appealed the trial court's decision to the Michigan Court of Appeals.

Briefs were filed in this action in support of Pioneer's motion to dismiss by Pioneer, the Michigan AG and Commissioner and NAMIC. The only issue before the court, as the court framed it, was ".whether policyholders have a right to compel distribution of surplus and whether the business judgment rule shields directors when they do not make the distribution." The business judgment rule is a rule of law that protects the decisions of boards of directors as long as the decision is not the result of fraud or serious abuse of discretion.

The court of appeals issued its decision on August 28, 2003 and held that a right to compel dividends by mutual company policyholders does not exist if there is no bylaw, statute, or contract provision according such a right. It further held that unless facts are alleged that would indicate that the business judgment rule does not apply, the rule does protect a board when they do not make a distribution of surplus to policyholders. A concurring opinion of the court simply reiterated that no right to compel dividends exists for mutual company policyholders and that, as a result, the courts discussion of the business judgment rule was unnecessary.

Plaintiffs now have several days to either request a reconsideration of the case by the Court of Appeals or they may appeal this decision to the Supreme Court of Michigan.

This case highlights a recent trend in cases attempting to force mutual insurance company boards to distribute company surplus to policyholders in the form of dividends. NAMIC has also been significantly involved in each of these cases, generally participating as the only trade association filing a full brief of the issues as an amicus.

Court Documents

Court Decision - Michigan Court of Appeals

State Farm v. Lopez

Finally, some of the same issues are presented in the case of State Farm v. Lopez, a Texas class action lawsuit filed to compel dividends to be declared for the benefit of Texas State Farm auto insurance policyholders.

The case is currently on a petition for review by the Texas Supreme Court after the Texas Court of Appeals confirmed a trial court's class certification of more than 2 million policyholders from 1994 to 1999 seeking to compel dividends. As State Farm presented in its brief to the appeals court, the issue in this case can be framed as follows:

So the question is: should a jury in Texas and each of the 49 other states be able to decide that a national insurance company should pay out billions of dollars of its policyholder protection fund (surplus) in dividends to that state's policyholders? Or should the size of the policyholder protection fund be based on the business judgment of the company's board of directors, subject to regulatory review in its home state?

The policy provision relied upon by the plaintiff's in the Lopez case is a part of the standard Texas auto policy that is prescribed by the Texas Department of Insurance for mutual insurance companies. In addition, Texas law expressly prohibits an insurance company from promising a dividend to its policyholder (Section 5.102).

Similar to the Pioneer case in Michigan, State Farm has argued in the Lopez case that the court lacks the jurisdiction to hear the plaintiff's case since Illinois law governs the internal affairs of State Farm and Illinois would allow such a suit only if brought by the Illinois Attorney General at the request of the Illinois Director of Insurance. State Farm has also appealed the decision since the class included both present and former policyholders. State Farm argues that the beneficial interest of current policyholders in State Farm's ability to pay claims as a result of its surplus is antagonistic to that of past policyholders who have no such interest.

The Texas Court of Appeals rejected the arguments of State Farm and affirmed the class certification approved initially by the trial court. The case is now on petition for review by the Texas Supreme Court and a ruling on that petition is expected shortly.