The refusal to approve the HIH scheme in its current form is a reminder that schemes of arrangement cannot simply be pushed through the courts, explains Peter Clarke.

HIH was the second largest insurance company in Australia before becoming the country's biggest ever corporate failure in 2001, collapsing with losses of $5.3bn and leading to extensive investigations, legal proceedings, high profile convictions and liquidation. The HIH scheme of arrangement was finally approved on 26 May 2006, but not before a small clause in the scheme was removed at the judge's recommendation. With the potential to derail the scheme altogether, the lessons from this case should not be ignored.

On 25 May 2006, Justice Barrett delivered judgment on the Australian HIH scheme, illustrating the fact that a small clause in a scheme document can have a large impact. Cobalt had raised concerns with the liquidator's legal representatives regarding the implications of certain provisions of the scheme documentation, in particular, the "common liability" provisions in clause 22.4.

The impact of clause 22.4 is best examined in the context of the potential operation of "co-insurance" where one of the co-insurers is a schemed HIH entity. After a loss on a policy written on a co-insurance basis, one or more of the co-insurers (other than a schemed HIH company) settle their share of a claim for an amount less than their liability in respect of the claim. A settlement of this nature is not uncommon and may occur for a range of commercial reasons. Often an insurer's approach to a settlement such as this is driven by their particular situation. The insured's decision to accept a partial settlement may not be reflective of the position of the remaining co-insurers, nor of the potentially different views of the insured toward the different co-insurers.

In this scenario the proposed HIH scheme incorporating clause 22.4 had the potential effect of allowing the HIH entity to "piggyback" off commercial settlements made by their co-insurers. In other words, the HIH scheme entity would have been able to settle at a reduced amount.

It could be argued that the entitlement of the HIH scheme entity to benefit from a co-insurer's prior commercial settlement appears unfairly advantageous. This argument is made given that no assessment has been made of the different circumstances of the various co-insurers, nor the appetite of the policyholder to settle with one insurer at one amount and with another at a different amount, for a myriad of commercial reasons.

Conversely, it could be reasoned that clause 22.4 appears reasonably efficient in that it had the potential effect of overcoming the need of the liquidator to fight the same battle of a co-insurer (saving time and legal costs) as well as equitable in that the schemed entity only benefits from other "reduced" settlements on an average basis.

There are at least three knock-on effects from the removal of clause 22.4 from the scheme: - First, so far as a reinsurer assuming HIH liabilities is concerned, the status quo of the original reinsurance contract has been restored. Reinsurers will now not enjoy the windfall gain that might otherwise have arisen had HIH been able to restrict its liability under clause 22.4. Arguably most reinsurers will be debtors rather than creditors so most reinsurers will not now receive the positive benefits that may have arisen had clause 22.4 remained. - Second, the definition of common liability is any "liability arising under a contract of insurance, reinsurance or retrocession". Under clause 22.4, HIH would be entitled to pay reinsurance recoveries to a reinsured on the basis of the average overall settlement made by their co-reinsurers. In circumstances where a panel co-reinsurer had agreed a commercial settlement with the reinsured for less than their liability under the policy, the reinsured's recovery would have been lessened.

The HIH scheme entity as reinsurer would have been able to settle at a reduced amount (based on their proportionate share of the policy limit and the average overall settlement of all co-reinsurers). Now that the status quo of the original reinsurance contract has been restored, reinsureds will now not be impacted negatively as they would have under clause 22.4. - Third, a creditor who is also a debtor of a company as of the date of the winding up (such as a reinsurer with both ceded and assumed liabilities) will retain the full rights of "set off" (or the right to combine accounts) available to it in the liquidation of the scheme company. These rights allow, in most cases, a debtor to set off the amounts owing to a scheme company against amounts owing by the same scheme company at 100 cents in the dollar. Only the shortfall will be payable to the scheme company or provable in the scheme (as the case may be).

The decision

Justice Barrett refused to approve the scheme in its then current form accepting (for the most part) Cobalt's submissions on behalf of Gordian Run Off. Essentially, he considered that:

- Clause 22.4 of the scheme prejudiced creditors with common liability claims;

- That the court had no power to grant approval to the scheme because there was no separate assent of the class of creditors with common liability claims;

- There was not adequate disclosure of the prejudice to these creditors in the explanatory memorandum;

- The disclosure at the meeting of creditors did not remedy the position. He considered that many creditors would not have been aware of the issue at the time of voting as they did not attend the meeting in person and the issue was not properly disclosed in the memorandum; and

- Creditors with common liability claims were not given information of very real importance to them.

Accordingly, the court decided that it would not approve a scheme containing clause 22.4.

Lessons from the decision

At a high level the decision reinforces one key principle concerning schemes: the application of schemes for purposes of finalising liabilities within insurance entities is not an exercise in commoditisation. They are not an "off the shelf" solution. This decision, and others in the UK, notably BAIC, has demonstrated very clearly that schemes are not a "one size fits all", nor are they a mechanism that can be pushed through the courts regardless of the mix of creditors. Scrutiny by the courts will increase, not diminish, as the body of scheme experience grows and new and complex issues emerge.

The HIH decision also emphasises the need for the scheme manager, in this case the liquidator and their advisors, to properly disclose all material matters which affect the rights of creditors. If the scheme materially affects a group of creditors, this prejudice should be disclosed in the explanatory material sent with the scheme and the affected creditors should vote at a separate meeting.

Moreover, creditors should not assume that the scheme manager is in a position to identify the issues which could affect them as a creditor. In this case, Cobalt identified that a class of creditors would be adversely affected by the scheme. This effect was not disclosed in the explanatory memorandum, or in any of the pre-meeting applications. Individual creditors must assess a scheme carefully rather than assume the scheme approach is fair for them. Creditors should also have a good understanding of their own portfolio so that they are in a position to identify the effect of any proposed scheme on their rights.

Based on the HIH Australian scheme experience, creditors might consider more carefully the benefits of physical attendance at scheme meetings and court hearings. It would seem that some creditors take a view that the scheme process is largely inevitable and that their interests will be generally protected. In this context, creditors could mistakenly believe that attendance at scheme meetings is unimportant.

The experience has also lent weight to the idea that it may be beneficial for offshore creditors to liaise with local, specialist service providers during the scheme process. Local professional firms will generally offer insights into regional issues that may not be identified by a creditor operating at a distance and in a different jurisdiction. They can also be available to physically attend scheme meetings where creditor attendance is not possible.

Lastly, as is the case with all insurance matters, read the policy documents carefully and do not ignore the small-print - a small clause can have a large impact.

- Peter Clarke is the managing director of Cobalt Solutions.