In light of the recent BAIC decision - now on appeal - Richard Gregorian and Devi Shah question what this means for future run-off cases

The scheme advisers of the future, contemplating their return to school after the summer holidays, must not have been the only ones who regarded a return to work with trepidation, in light of the British Aviation Insurance Company(1) (BAIC) case. Those involved in the run-off industry are waiting to see whether the hopeful start to the term offered by Mercantile & General (sanction granted by Scottish Court of Session on 1 September) is a return to "normality" or a false dawn. BAIC is now the subject of an appeal.

The issue of class

BAIC is the first time a solvent scheme of arrangement has been comprehensively opposed at sanction, including in relation to class. Justice Lewison held that convening a single class of creditors for the purpose of voting on the scheme was insufficient and deprived the court of jurisdiction to sanction the scheme. It has been mooted in the marketplace, however, that the judge's reasoning can support outstanding loss claims being grouped with IBNR for the purposes of voting. This will leave agreed/unpaid loss claims in a separate class of their own, which can be extinguished by payment before the scheme is launched.

The judge's reasoning for two classes was that, in applying the established tests for determining classes (essentially, can the scheme creditors sensibly consult together in their common interest having regard to their legal rights and the manner of treatment of those legal rights in the scheme?), one must compare what rights scheme creditors would realistically have in the absence of a scheme. In the case of a portfolio scheme, like that in BAIC, this most likely means solvent run-off. BAIC had sought to argue that the relevant comparator should be a solvent liquidation which, by analogy with what has been accepted in relation to insolvent schemes (Hawk Insurance Company Limited (2001), Court of Appeal), had led to scheme creditors being grouped into one class (on the basis that the universal valuation and dividend payment provisions in the Insolvency Act 1986 are the only alternative). These rules also apply to solvent liquidations.

In a solvent run-off, the scheme creditors in respect of agreed/unpaid losses will receive payment in full on their claims on an indemnity basis, and they are in a similar position if a scheme is implemented. On the other hand, scheme creditors in respect of IBNR, instead of receiving payment in full on an indemnity basis as and when their claims fall in, will receive payment of an amount equating to an estimate of their future entitlement to an indemnity calculated by the scheme estimation mechanism.

Justice Lewison held that outstanding loss claims should be grouped in a class with agreed/unpaid losses due to the fact that they, unlike IBNR claims, have already accrued and do not require valuation by reference to complex actuarial techniques, including an estimation of the probability of the event giving rise to the outstanding loss. It made no difference to the court's decision that there may be scheme creditors with overlapping claims. Such overlap would not be universal due to the inevitable existence of scheme creditors with pure IBNR claims in any event.

Those who advocate grouping outstanding loss and IBNR claims together cannot escape the judge's clear distinction that it is the fact that agreed/unpaid and outstanding loss claims have accrued that makes it appropriate for them to be classed together.

The requirement for two classes runs counter to the pragmatic approach the courts have taken on class in recent years, driven by the need to avoid numerous technical divisions which give minorities the ability to block schemes. Indeed, in Mercantile & General, having been addressed on Hawk and on BAIC, Lord Clarke decided that scheme creditors with agreed, outstanding and IBNR claims could properly consider and approve the scheme at a single class meeting if thought fit to do so.

Justice Lewison further considered - but was not persuaded - that scheme creditors who also reinsured the company constitute a separate class. However, BAIC does not provide unqualified authority in respect of convening two classes. It does not, for example, consider whether a separate class meeting should be convened in respect of IBNER (incurred but not enough reported claims(2)), which share characteristics of both agreed/unpaid losses and IBNR. Rather, it provides a reminder for the need for focused actuarial and legal analysis in relation to class issues. Nor should it be assumed, based on BAIC, that whole company schemes can be progressed on the basis of one scheme meeting in every single case. The issue of the appropriate comparator will need to be decided in each case.

Solvency issues

As Justice Lewison had concluded that he lacked jurisdiction to sanction the scheme, his reasons for holding that he would not - as a matter of discretion - have sanctioned the scheme are not binding. Advisers will, however, have to take his comments on board at least until those comments are reviewed by a subsequent court. Broadly speaking, BAIC requires scheme promoters to consider the following issues:

The overall fairness of solvent schemes - The most powerful consideration for refusing sanction on discretionary grounds was the perceived unfairness of compulsorily re-transferring the risk of exposure for long-tail claims, which direct insureds (who are not in the risk business) have paid premiums to insurers (who are) to accept. The same argument could be made for reinsureds, who by retroceding their exposure signal that they wish not to be in the "risk business" with respect to the retroceded business. Scheme promoters will need to do more than argue that creditor democracy should prevail. They will need to address Justice Lewison's interpretation of the legal basis for refusing discretion (including the "honest and intelligent creditor" test) and ensure that the advantages of schemes to creditors are demonstrated in the evidence, for example: early conclusion of the run-off (leading to cost savings for insureds and reinsureds); early payment (with a favourable level of discounting); and a truncated adjudication mechanism rather than possible protracted litigation.

Bar date - Justice Lewison would have required a one-year bar date. In cases where there are good reasons for proposing a shorter bar date, one solution may be to ask the creditors to vote on the earlier bar date whilst bringing the issue to the court's attention. The scheme can be amended at sanction without the creditors being required to vote again provided the amendment is not prejudicial to scheme creditors.

The need for an estimation methodology - Justice Lewison noted that the BAIC estimation methodology was no more than an explanatory note as to how scheme creditors should support their claims for payment purposes. He concluded that a vague estimation methodology might lead to an inconsistent treatment of IBNR claims, a matter going to the court's discretion as to whether to sanction the scheme. Proposers of schemes will either need to present an estimation methodology which provides a clear basis for treating scheme creditors alike (which in view of the nature of the business may be difficult) or provide convincing evidence that such an estimation methodology is not possible or appropriate.

Reversion to run-off - Justice Lewison was unsatisfied with a clause that gave the company an unfettered right to elect to run-off in undefined circumstances solely beneficial to it and without prior consultation with scheme creditors. Scheme proposers should be willing explicitly to define the circumstances in which the company may elect to run-off and the consequences of reversion.

Voting - Justice Lewison fired a number of warning shots in relation to voting. First, like connected creditors, scheme creditors with outwards reinsurance cross-claims could be special interest voters. He noted that reinsurance scheme creditors have an economic interest different to direct insureds and reinsureds without set-off rights, since they are interested in capping IBNR claims against the company because this caps IBNR debts to the company.

The most important lesson is the reminder that IBNR must be valued responsibly. The chairman of the meeting of scheme creditors is required to ascribe a genuine value to the claim and cannot simply place a nominal value on the claim, even in the absence of sufficient or any information supplied by the creditor (especially where the company itself has made reserves in respect of such claims). With many companies having generic reserves not appropriated on a policy-by-policy basis, this may be difficult.

Richard Gregorian and Devi Shah are lawyers at Mayer, Brown, Rowe & Maw LLP.

References

1. Re British Aviation Insurance Company Limited (2005) EWHC 1621 (ChD).

2. Where a claim has accrued and liability and initial quantum has been agreed but the valuation of the indemnity may increase with time, for example, as a claimant's need for (and cost of) medical care increases and subsequent claims are made.