A recent court decision has helped to clarify the uncertainty surrounding schemes of arrangement, says Adrian Savage

In recent years, schemes of arrangement pursuant to section 425 of the Companies Act 1985 have become commonplace as a means for solvent (re)insurance companies to exit all or part of their business. This is done by terminating their liability to policyholders in exchange for the payment in full of the estimated value of future claims.

A company wishing to implement such a scheme applies to the court for permission to convene a meeting or meetings of creditors to vote on the proposal. The application will set out details of how it proposes to conduct the meetings, including specifying the classes, if any, into which creditors have been divided for the purposes of voting.

Assuming that the meetings approve the scheme by the requisite statutory majorities, the court will be petitioned to sanction the scheme, after which it may become effective.

The defining feature of a class of creditor for the purposes of voting is whether creditors' rights, and the effect of the scheme upon them, are sufficiently similar for them to consult together with a view to a common interest.

Scheme withdrawn
The vast majority of such schemes have been approved by creditors, sanctioned by the court and successfully implemented. However, in 2005, a solvent scheme proposed by the British Aviation Insurance Company (BAIC) was opposed at the sanction hearing on the grounds that creditors with incurred but not reported (IBNR) claims formed a separate class and should have voted at a separate meeting from creditors with notified outstanding claims and claims that had been agreed but not paid. The court agreed and as a result that scheme was withdrawn.

The BAIC judgment left a considerable degree of uncertainty in its wake. Lawyers were left scratching their heads as to how, and indeed whether, the fate of the BAIC scheme could be avoided by other solvent insurers wishing to propose section 425 schemes.

The kernel of the decision was the judge's concern at the position of direct policyholders with exposure to insured long-tail claims, but little, if any, claims history. They had purchased policies and paid their premiums in exchange for their insurer assuming the insured risks. Their insurer was now proposing to terminate their cover in exchange for payment calculated in accordance with a scheme.

US interests
The opposing creditors in BAIC included US corporate policyholders in the aviation sector with exposure to long-tail asbestos-related claims. Their fundamental concern was the risk that, if the scheme was implemented, the payments that they would receive would not prove to be adequate compensation for the loss of cover. The respective actuarial evidence in BAIC showed there was disagreement as to whether the liabilities could be satisfactorily valued, never mind how.

In another proposed scheme, Willis Faber (Underwriting Managerial) Limited (WFUM), the proposers argued that the BAIC judgment should not be followed and that it was

appropriate for single meetings to be convened by each of the solvent companies. The rationale, in summary, was that all policyholders had the same right: to be paid their claims in respect of insured losses as they matured.

The fact that their claims might have reached different points of maturity, and hence certainty, on a "conveyor belt" or continuum between IBNR and paid claims was not sufficient to put them in separate classes. Furthermore, any given creditor may have multiple claims at different points on the conveyor belt, which further complicated the question of how the creditor population should be divided into classes.

Mr Justice Warren of the High Court, however, determined that "different policyholders with different mixes of claim have different rights". Put another way, although all policyholders holding similar policies may in theory have the same right to claim an indemnity as their claims mature, their actual rights will vary according to the maturity of their claims. Critically, the estimation methodology provided for by the WFUM scheme would apply differently in the case of outstanding claims and IBNR claims respectively.

Until it is finally agreed, there is some degree of uncertainty as to the value of a claim, but, broadly speaking, an outstanding claim is likely to be less uncertain than an IBNR claim. The value of an outstanding claim may be almost certain, while IBNR claims, by their very nature are estimates of the value of claims about which nothing concrete is yet known, although they are believed to exist.

Thus, there should be a line drawn between IBNR claims, requiring actuarial estimation, and outstanding claims, which do not, and separate meetings convened of the relevant policyholders of each solvent company, even if this means some policyholders voting in both meetings.

The WFUM judgment is a clear and important victory for the opposing creditors, although not the end of the matter. Many of them will believe that they have coverage of significant exposures to latent claims and hence substantial IBNR claims. Voting those claims in separate meetings of creditors will give them significantly more leverage either to vote down the scheme and retain their coverage, or ensure that the terms of the estimation methodology are acceptable to them in that they are likely to be, in their view, compensated adequately for the loss of continuing cover.

Even if the scheme is approved by the meetings of creditors, it will be open to creditors to oppose the sanctioning of the scheme by the court and prevent it becoming effective.

Benchmark decision
Although only a first instance decision, the WFUM judgment goes some way to clearing up the uncertainty following the BAIC judgment, which concluded that the classes had not been properly constituted for voting purposes, but did not set out a basis that would have been acceptable. The WFUM judgment is clearly expressed to be based on the particular circumstances of the WFUM scheme, but it at least provides something of a benchmark.

In summary, solvent schemes are likely to be vulnerable to attack in the future if a separate meeting is not convened of long-tail direct policyholders with potential IBNR claims. This gives a measure of protection to such policyholders if they are unhappy with the actuarial methodology proposed as part of a scheme, or simply prefer to retain their cover.

A possible consequence of this is that schemes for some books of business may no longer be feasible. Certainly, companies contemplating schemes will need to attend carefully to the concerns of such policyholders. IT

' Adrian Savage is an associate at DLA Piper Rudnick Gray Cary