Evolving societies: The mutual principle that underpins the mighty building societies and insurance companies is under fire. They must prove that there are still advantages for members. Richard Thomson looks at their past - and future

When Brian Pitman, the chief executive of Lloyds Bank, declared his intended purchase of the Cheltenham & Gloucester building society last April, he adopted a fearsome battle-cry. The takeover, he said, 'will so upset the competitive equilibrium in our favour that we should be able to win against the competition'.

But it was not the competitive challenge that struck terror into the building society chiefs. What scared them and a host of other executives in Britian's vast mutual company sector was the apparent challenge to their way of life. If the bid succeeded, it might open the floodgates to a host of takeovers, friendly and hostile, that could wipe out the mutuals - and the building societies in particular - in a few years. Speculation has been rife about possible predators, such as BAT Industries, Abbey National, the TSB or even Winterthur, the Swiss insurer. The building society industry has come close to panic.

Since the 17th century, Britain has been a crucible for a form of popular capitalism at least as old as the stock market. The essence of mutuality was financial self-help on a small scale. A few individuals would band together to form a company over which they had direct and democratic control and which, because it paid no dividends to shareholders, could offer better value to its members.

For two centuries, mutuals have grown steadily. But with the C&G deal, all three main branches of mutual organisation - building societies, insurance companies and the co-operative movement - have been stricken with self-doubt. Their numbers are falling, their future is uncertain and all of a sudden they are being asked to justify why they should remain as mutuals.

'All forms of corporate governance need to justify themselves,' says Fred Crawley, chief executive of the Alliance & Leicester building society, who, as a former executive of Barclays, has worked on both sides of the fence. 'How does mutuality justify itself these days?'

Lloyds was offering all C&G investors and borrowers a one-off bonus of up to pounds 10,000 to accept the takeover deal. The original offer was blocked by the High Court on the grounds that depositors of less than two years' standing were not entitled to a payout. But Lloyds and C&G will no doubt come up with a new formula. The question, however, that has caught the attention of the public and is worrying the societies is that if Lloyds could unlock so much hidden value in C&G and hand it over to the members, why should the members of other societies not demand the same? Are they, in short, getting real value out of mutuality?

Building Societies

Andrew Longhurst, the chief executive of C&G, said he had decided to link up with Lloyds because the society had evolved beyond the point at which mutuality is any help to its members.

Certainly, most modern societies would be unrecognisable to the founders of the industry. The first known building society was founded in 1775 by Richard Kettley at the Golden Cross Inn, Birmingham. The industrial revolution, the widening middle class, the growth of towns and the development of civic and social organisation in the 18th century all played a part in the appearance of small local organisations specifically designed to enable members to own their own houses. They grew quickly throughout the Midlands and the North, although they took another 30 years to catch on in London.

The societies were formed by 10 or 20 individuals agreeing to pay regular subscriptions into a fund that would be used to build (rather than buy) a house for each of them in turn. Total subscriptions per member were generally around pounds 80 to pounds 120. Usually, members drew lots to decide in what order they would receive their houses. Once all the properties were built after 10 or 15 years, the society was wound up.

These 'terminating' societies were a huge success. By 1845 there were at least 2,000 in Britain. Some had grown to 250 members and were starting to accept deposits from people who had no intention of building or buying a house, but simply wanted to save their money.

Then in the 1840s came a new idea: the permanent society. These had a rolling membership, so that new members were constantly being recruited to replace the old members as their 10-year or 15- year spans ran out. Borrowers and depositors, moreover, ceased to be the same people.

There was a new explosion in the number of societies founded, with 2,740 in existence by 1860. Then began the steady consolidation that continues today: in 1910 there were 1,723 societies, in 1926 the Building Societies Association had 310 members (though much of the industry did not belong) and there are 87 societies now.

The dissociation of borrowers and lenders in permanent societies was a significant step beyond pure mutuality. An even bigger step, however, was the growth in their size. Permanence enabled societies to grow first to hundreds of members, then to thousands, then hundreds of thousands.

'When you get vast nationwide organisations, it is doubtful how mutual they really are,' says Mr Crawley. 'But it does give a lot of protection to society boards. They are virtually fireproof.'

True management accountability, in other words, has virtually vanished. At least the institutional shareholders of, say, Barclays Bank may exert pressure on management when they feel things have gone wrong. But none of the 6 million individual members of the Halifax Building Society, each with a single vote, can ever hope to exert any influence whatever on the society's board.

Building society legislation condones the unquestioned power of the managers. A board can, for example, simply refuse to put a takeover proposal to the society's members if it does not suit them.

And what advantages does mutual status confer on those members? Most depositors would probably be hard put to say. The standard society response is that since they do not have to pay dividends to shareholders, they have more money to pay out to investors than, say, the banks. Although that assertion is impossible to verify since deposit rates are continually changing, no one claims that building society rates are consistently substantially more generous than their rivals among the banks.

Instead of going into the pockets of society members, much of the surplus building society profit has in recent years gone into funding expansion into new areas, such as estate agency and insurance. But it is far from clear that this has been in the best interests of members - as seen, for example, in the millions thrown away on buying estate agencies in recent years by such societies as Nationwide.

So far, few building society managers are willing to give up the idea of mutuality. Instead, they are having to do some hard thinking to defend it. 'We haven't been giving justifiable extra benefits to our members,' says Mr Crawley. 'After the C&G offer, we are asking how we can best use our surplus capital for our members' benefit.' Ideas recently mooted by Rosalind Gilmore, the building societies regulator, are to offer higher deposit rates or to pay regular membership bonuses.

Whether this will be enough to persuade members of the continuing benefits of mutuality is questionable. In practice, however, the number of societies is certain to continue shrinking through friendly merger with other societies. Many believe that the medium- sized societies will eventually disappear, because they have neither the muscle of the big boys nor the loyal local customer base of the tiddlers. Meanwhile, large societies such as the Halifax which are determined to remain mutual are probably just too big to be bought by anyone.

The societies, after all, have two great advantages. One is that customers continue to see them as more user-friendly than banks (although the experience of the Abbey National shows incorporation need not change an institution's character). The other is the Building Societies Act, which requires a 75 per cent majority of a 50 per cent minimum turnout of members to agree a takeover. Most experts see this as a virtually insuperable obstacle to hostile takeovers.

Insurance companies

In the mutual insurance sector, the future also looks grim. At least four of the smaller companies have recently been taken over by companies outside the sector, including Scottish Mutual's absorption by Abbey National last year and Scottish Equitable's purchase by Aigon, the European insurer, when it ran into a shortage of capital.

Mutual insurers face a set of unprecedented problems. They are, for example, selling insurance in a market that is swinging away from independent brokers towards teams of tied agents and bancassurance as methods of reaching customers. Traditionally, the mutuals have relied on the brokers and, without access to equity capital, many companies may have trouble finding the money to set up their own teams of tied agents. In the meantime, they are having to pay higher commissions to the brokers.

There is also a shift away from traditional endowment policies towards unit-linked policies in the insurance market. That inevitably undermines mutuality, because unit-linked policy-holders have no mutual rights.

Like the societies, mutual insurance companies emerged as a response by the growing middle class to the need to use and protect its new affluence. Societies for mutual assistance had existed among craft guilds and religious and military-aid societies since the Middle Ages. Friendly societies were invented to offer general help to their members, but formal insurance companies appeared only in the 17th and 18th centuries.

One of the first, the Hand in Hand, founded in 1696, was a mutual. Policy-holders paid an annual premium and an initial deposit, were liable to underwrite any loss up to 10 shillings per pounds 100 insured, but participated in any profits from investing initial deposits.

Several mutual life insurance companies were set up in the early 18th century, but it was the Society for Equitable Assurances on Lives and Survivorships - Equitable Life - founded in 1756, that pioneered the use of mortality tables. Mutual insurance companies were popular partly because of the profound damage to public confidence in joint stock companies caused by the South Sea Bubble scandal of 1720.

As the mutuals grew, their managers discovered, just like their colleagues at the building societies, the joys of mutuality. Accountability to individual members became negligible and mutual companies were almost completely proof against takeover. Over the years prominent proprietary companies spotted these advantages and jumped on the bandwagon.

Standard Life, now the largest Scottish office, was established in 1825 but converted to mutual status in 1925 specifically in order to avoid takeover. Standard paid off its shareholders with a handsome pounds 675,000 from reserves. Scottish Mutual, formed in 1881, abandoned proprietary status in the 1920s, while Clerical Medical converted in 1961, and Scottish Life in 1968 - also to avoid takeover.

But Standard Life cited another reason for converting: it 'drew the fangs from the charge that profits were going to shareholders rather than policy-holders.

'Proprietary life companies traditionally pay 10 per cent of profits to their shareholders and the other 90 per cent to policy- holders. Mutuals are free to pay 100 per cent to policy-holders.' In theory, too, they can afford to take longer-term investment decisions, which should improve their performance. So mutual policy-holders get a better deal?

Well, no, in general they do not. In a lengthy study last year into mutual life companies for the Life Assurance and Unit Trust Regulatory Organisation, Robert Carter, Professor of Insurance Studies at Nottingham University, concluded that mutuals as a group performed no better than proprietary companies. Comparing 18 mutuals with 15 quoted companies on a range of products over a 10- year period, he found that 'mutual status was not statistically significant in explaining the differences between the sample life office in product performance'.

While the rationale for mutual life companies looks paper-thin, however, there seems little likelihood they will disappear in the foreseeable future. 'The whole market is rationalising and changing and the numbers of small mutual companies will fall - but so will the number of small proprietary companies,' says Professor Carter. Small mutuals are already suffering from the lack of access to equity capital but, says Professor Carter, 'the majors don't seem constrained by capital'.

Co-operatives

The third main branch of 'people's capitalism' has also had its hardships in recent years. 'Ten years ago we were bleeding to death,' says Ian Williamson, spokesman for the Co-operative Union. Since then, the movement has put its house in order, but now fears the Lloyds-C&G deal could precipitate an avalanche of hostile takeovers of the Co-ops.

Peter Walker, executive director of the Co-operative Council, called recently for greater legislative safeguards against bids than the simple 75 per cent majority required of members voting in favour.

There are unquestionably rich pickings for potential predators from the movement, which marks its 150th anniversary this year. In 1844 a group of 28 cloggers, tailors and hawkers set up shop at 31 Toad Lane in Rochdale. Their counter was a trestle table on which they had for sale four sacks of grain, some sugar and butter. The so-called Rochdale Pioneers wanted to counter the widespread practice of adulterating food, aiming to provide pure food at reasonable prices.

Members bought a share in the business and dividends were paid according to how much the shareholder bought from the store - a kind of deferred discount. The idea swiftly took off. In 1845 the Pioneers opened a butcher's department, then a drapery department. The Co-operative Wholesale Society opened in 1863, an Insurance Society in 1867 and the Co-op Bank in 1872.

For many years the movement remained truly mutual, with hundreds of small local Co-ops serving their own communities by opening shops where no other business would have opened one. By its heyday in the 1950s, it was Britain's biggest grocer. Then came the white heat of competition. With its cumbersome federal structure, the movement failed to respond to developments such as the growth of supermarkets and its market share slumped in the 1970s and 1980s.

But the Co-ops rallied, consolidated, and began to reinvest what capital they had left. The food retailing business is not growing, but the movement remains a Leviathan. It has three million members and reserves of pounds 935m, is still the third largest food retailer and the biggest farm operator in Britain, has a quarter of the funerals market, is the third largest travel agent and runs the third biggest chain of pharmacies.

The Co-op still stoutly defends itself as a social service. 'Profit is not our main motive,' insists one manager. Yet some executives acknowlege there are serious problems. 'Many of the big Co- ops have lost their purpose,' concedes Terry Thomas, head of the Co-op Bank. They suffer from the familiar problems of lack of accountability, they are no cheaper than other food retailers, and most Co-ops long ago abandoned the member's dividend.

No wonder they are afraid their members will sell them out to the first predator who promises a large enough pay-off.

The mutuals have for decades been living on their history. Now that they are having to justify themselves, for almost the first time in a generation, their arguments do not sound wholly convincing. It is not clear that members get a much better deal than the shareholders or policy- holders of comparable joint stock companies; on the other hand, the managements are relatively unaccountable. So far, accountability has not been much of an issue because the mutual sector is heavily regulated. But the first time a substantial building society or mutual insurance company runs into deep financial problems or is involved in serious financial fraud, the accountability of management will become a key issue.

Yet predictions of the imminent demise of mutuals are premature. They are too large and too heavily protected by the law to disappear, unless they themselves decide to change their status. A Treasury review of the Building Societies Act which is expected soon is likely to widen their powers and perhaps even relax their regulation, further removing the incentive to give up mutuality. And the mechanism of individual voting, by which members can put pressure on their managements, is so cumbersome that it is unlikely to force rapid changes on the sector.

In the meantime, however, the mutual idea is quietly re-inventing itself. Over the last 10 years, small bands of lawyers and accountants, for example, have been forming their own mutual companies to provide indemnity insurance that they could not buy elsewhere. New mutuals have been founded to provide insurance for housing associations. In the Co-operative movement there are calls for new organisations to cope with the state's inability to provide adequate educational and health facilities. And small co-operatives continue to be formed with only a few members. It would be these, rather than giant financial institutions like the Halifax, that the 18th-century pioneers would recognise as keeping faith with their idea of mutuality.

(Photograph omitted)