Insolvency legislation will soon provide two additional powerful tools for the insurance insolvency practitioner's kitbag: Administration and Company Voluntary Arrangement (CVA). These procedures will affect the way in which insolvent UK insurance companies are dealt with, adding more options to the practice for dealing with non-life insurance insolvencies developed over the past decade.
Under current practice, the process starts with the presentation of a petition for a winding up order immediately followed by the appointment of a provisional liquidator. Once the provisional liquidator is in place, the company is protected from creditors commencing or continuing actions against it. Under this moratorium, maintained by repeated adjournments of the hearing of the original winding up petition, the provisional liquidator will take control of the company's assets, investigate the company's affairs, convert the company's accounting systems from net accounting to principal-to-principal accounting and devise an exit mechanism for handling claims of creditors, collecting reinsurance recoveries and distributing dividends.
At the moment, the favoured mechanism is a bespoke scheme of arrangement because it maximises returns to creditors and provides for early payment of dividends. Alternative exit routes are liquidation and CVA. UK liquidation is a cumbersome administrative procedure, comprising many rigid rules. In addition, it is particularly expensive: the government levies an ad valorem fee on all receipts and the company loses the ability to carry forward tax losses. However, liquidators are given valuable powers to apply to court to overturn preferences and transactions at undervalue, and to bring wrongful trading actions against directors and shadow directors.
A CVA is very similar to a scheme of arrangement and has the same advantages over liquidation. However, as it is currently drafted, the CVA procedure contains a fatal flaw making it practically unusable for insurance companies: it only binds those creditors given notice of a meeting to consider the CVA proposal. Therefore, unknown creditors – included in incurred but not reported (IBNR) – will not be included by the CVA.
Schemes of arrangement have their faults as well. In particular, a criticism is the long period between the appointment of a provisional liquidator and the launch of a scheme, and the consequent delay in payment of dividends to creditors. Apart from complexity issues, one of the main reasons for delay is the investigation into the company's affairs for potential preferences, transactions at undervalue and wrongful trading. These may be of significant value, recoverable for the benefit of creditors by a liquidator and may exceed the advantages provided by a scheme. Not to conduct such an investigation may cause a loss to creditors.
Scheme administrators have no powers to attack preferences and transactions at undervalue, nor can they bring wrongful trading actions. Recent developments in schemes have attempted to overcome these weaknesses, for example by enveloping scheme assets and scheme liabilities in a trust, separate from the company. This will allow the company to be placed into liquidation, which does not apply to the trust, making available the powers provided to a liquidator to pursue potential recoveries. The recent scheme for Anglo American Insurance Company Ltd used just this mechanism.
Another drawback with schemes is the requirement to establish different classes of creditors, where their interests are sufficiently different or are dealt with differently under the scheme, to warrant separate approval of the scheme by each class. In these cases, the difficulty is in correctly categorising each class. The class problem was highlighted recently with the proposed scheme for The Hawk Insurance Company Ltd: the court refused to sanction the scheme, despite having the support of its creditors, because creditor classes had not been correctly identified. The court's decision has been appealed in this case.
Reasons for change
The provisional liquidation/scheme process is accepted as the best available mechanism for dealing with insurance insolvencies in the UK. However, it is a contrived solution devised by insolvency professionals, and is not used for any other types of corporate insolvency.
In recognition of the lack of an appropriate procedure for dealing with insurance insolvency, in 1994 the UK government issued a proposal for a new procedure, specifically designed for non-life insurance insolvencies. The proposal sought to incorporate the best features of liquidations and schemes, plus create some new ones, and eliminate particular deficiencies of them. Unfortunately, lack of parliamentary time due to a general election in 1997 stymied attempts to add the procedure to the statute book.
Under the current government, the creation of the Financial Services Authority (FSA) provided another opportunity to address the problem. Rather than dust off the original Department of Trade and Industry (DTI) proposal, which had been drafted during the infancy of modern insurance insolvency practice, the Treasury has decided to make available Administration to insurance companies.
What is Administration?
Administration is a relatively new insolvency procedure, introduced by the Insolvency Act 1986. Its original purpose was to provide a mechanism for the rehabilitation of companies in financial difficulties analogous to the US Chapter 11 proceedings: no such procedure was hitherto available under UK law. Essentially, Administration provides protection to a company whilst a plan for restructuring or asset realisation is organised. The procedure has been used in many recent, high profile insolvencies (such as the Maxwell Group and Barings Bank) and has received international recognition, particularly from the US courts.
Administration originally applied to all UK-incorporated companies, except for banks and insurance companies, which were already subject to government regulation and supervision In 1989, the Insolvency Act was modified to remove the exclusion for banks. Under the Financial Services and Markets Act 2000, which is due to come into force later this year, the exclusion of insurance companies from the Administration process will also be removed.
Administration is commenced by order of the court, placing a company that is likely to or has become insolvent under the control of an Administrator. The court will only make an order if Administration is likely to achieve one or more of the following statutory purposes:
The administrator prepares proposals for the company, which if approved by creditors he will implement. An Administration order will only be made by the court if it is satisfied that the company is or is likely to become unable to pay its debts. A provisional liquidator can be appointed after a winding up petition is presented. By contrast, for a winding up petition based upon insolvency, the court must be satisfied that the company is unable to pay its debts. The difference in wording is deliberate.
This means that Administration may be used for the purpose of sanctioning a ‘near solvent' scheme of arrangement. The order will give the company the necessary protection to prepare such a scheme, unlike the current regime which does not provide a mechanism for assisting insurance companies in this situation. Had Administration been available, the ‘solvent' scheme proposed for Chester Street Holdings Ltd (formerly Iron Trades Holdings) in December 2000 may have been successfully launched. Instead, Chester Street Holdings went into provisional liquidation on 9 January 2001, and policyholders will suffer additional costs and delay as a new ‘insolvent' scheme is prepared.
If Administration is employed for insolvent insurance companies, it will be for at least two purposes; a better realisation of assets than in a liquidation, together with one or more of the other statutory purposes. A better realisation of assets is almost always achieved in Administration, on the basis of preservation of tax benefits if for no other reason, and while that is happening, the Administrators can start planning immediately for a scheme (or CVA) and even launch one during Administration. This allows the Administrator to pursue recoveries from preferences and transactions at undervalue while still in office. Therefore, all indications are that schemes and CVAs would be launched quicker with Administration than with provisional liquidation, meaning that dividends can be paid to creditors much sooner. One caveat concerning Administration must be mentioned, however: in relation to insurance companies, the Treasury has reserved the power to amend the Administration procedure as it sees fit, should it be considered necessary.
Change to CVA procedure CVA was introduced in the Insolvency Act 1986, and was developed to provide a corporate equivalent to the voluntary arrangement procedure already available to individuals in financial difficulty. It is a flexible tool very similar to a scheme of arrangement, and the terms of a CVA are designed specifically for each company.
In a separate change to UK insolvency legislation to come into play later this year, a CVA will bind all the company's creditors to it, whether they are known or unknown, not just those who have been given notice of it. This change will overcome the current flaw in the procedure from the insurance insolvency specialist's point of view.
With the forthcoming change, a CVA will be an alternative procedure to a scheme for insurance companies. There is absolutely no doubt that the introduction of Administration and the change to the CVA process will change insurance insolvency practice. Innovative insolvency practitioners will now consider both as real alternatives to provisional liquidation and schemes. Whichever mechanisms are chosen will depend upon the circumstances of the company and the particular advantages offered by each procedure.
UK insolvency legislation will soon be subject to further fundamental change. A European Union directive on the winding up of insurance companies has recently been agreed in the Council and is subject to final approval, expected later this year. Once the directive must be introduced into each EU member state's legislation within two years.
The fundamental change for the UK is that the directive requires claims of direct insurance policyholders (insureds) to be given priority over claims of reinsurance policyholders (reinsureds) and other unsecured creditors of the company.
Steve Goodlud is a senior manager in the corporate recovery practice of KPMG. He is a licensed insolvency practitioner and specialises in financial services business.