BAIC scheme of arrangement: sanction refused

United Kingdom

Judgment in the case of The British Aviation Insurance Company Limited ("BAIC") was given on 21 July 2005. The judge refused to sanction a solvent scheme of arrangement proposed by BAIC to its creditors under section 425 of the Companies Act 1985. The purpose of the scheme was to terminate the run-off of part of the company's insurance and reinsurance business.

A scheme of arrangement is an arrangement between a company and its creditors or any class of them. For it to become binding, first the court must allow a meeting or meetings of creditors to be called to consider and if thought fit approve the scheme. Then the requisite majority of creditors at the meeting (or each meeting) must approve the scheme. The requisite majority is a majority in number representing not less than 75% in value of those creditors who actually attend and vote at the meeting(s) (in person or by proxy). Finally the scheme requires the sanction of the court, and the court order must be filed with the registrar of companies. Court sanction is not a rubber stamp. It can be refused, as it was in this case, but such refusal is rare.

The question of how the classes of creditors are to be constituted for a particular scheme of arrangement often presents difficulties and has been the subject of several judicial decisions. The test is easy to state, but can be very difficult to apply in practice. A class of creditors comprises all those creditors whose rights are not so dissimilar that they cannot consult together. If there are creditors affected by the proposed schemes whose rights are not sufficiently similar that they can consult together, then they form a separate class of creditors. The determining factor will be how similar the rights of the creditors are before the scheme, and what rights they will have under the scheme.

If there is more than one class of creditors, there must be a separate meeting for each class to consider the scheme, and each class meeting must approve the scheme by the requisite majority for the scheme to become effective. If the company proposing the scheme gets the classes wrong and does not hold the right meetings, the court has no jurisdiction to sanction the scheme.

This is what happened in the case of BAIC. One meeting of creditors was called to consider the scheme, and it approved the scheme. BAIC had modelled its scheme along substantially similar lines to other schemes that had previously been sanctioned by the court. In fact over 40 solvent insurer schemes with only one class of creditors have in the past received court sanction. However, BAIC's scheme was opposed on a number of grounds by 18 direct policyholders (many of whom were from the same corporate group). The judge held that BAIC had not called the right number of class meetings, and refused to sanction the scheme.

The judge's decision was based on an analysis of the rights of those creditors who had claims relating to losses that had been incurred but not yet reported ("IBNR"). These rights were not sufficiently similar to the rights of creditors who had unsettled paid claims or outstanding losses so as to enable the relevant creditors to consult together.

The essence of a scheme of arrangement for solvent insurance companies is that creditors' claims are submitted, valued (by agreement or, if necessary, adjudication), and then paid in full at the values established in accordance with the provisions of the scheme.

For unsettled paid claims or outstanding losses, the valuation process under the scheme involves evaluating the quantum of claims that have already been reported. Those with paid claims or outstanding losses receive a full indemnity for their losses. For IBNR claims, the process involves estimating values for claims that could be made in the future. This in turn involves estimating the likelihood that such claims will arise in the future and, if they do, what their value will be. Therefore under the scheme, those creditors with IBNR claims no longer have the right to wait and see if the claims occur, and then receive an indemnity for such losses. The bargain offered by the scheme in relation to IBNR losses therefore is to swap a policyholders' right to make a claim in the future for payment now of an amount that is estimated to be the value of any such future claims. The estimation process in the scheme is based on claims history, among other things, and uses actuarial projection techniques.

An advantage of the scheme for creditors with IBNR claims is that their future, unmatured claims are paid (at the valuations so established) earlier than they would otherwise be if the insurance contracts were run off in the ordinary course. In some cases it can take tens of years for such a run-off to be completed in the ordinary course, particularly where the business includes latent claims, such as asbestos and pollution, as it did in the case of BAIC.

The judge decided that the difference in risk to the creditor in estimating IBNR claims compared to the risk of agreeing a value for claims that had already accrued meant that it was not possible for IBNR creditors to consult together with other creditors. Separate class meetings for these two groups of creditors should have been called. Because separate class meetings had not been called, the court had no jurisdiction to sanction the scheme.

The opposing creditors also objected to a number of other features of the scheme, and the judge commented on some of these. Strictly speaking these comments are not binding because the case was decided on the class issue and so the judge had no need to rule on the other points. However, the judge seemed to agree with some of the objections, the main one being that the scheme was unfair to direct policyholders.

The business that BAIC wanted to scheme included both direct insurance and reinsurance. The judge drew a contrast between the position of insurers (or reinsurers), whom he described as being in the risk business, and that of direct policyholders, who were not. The judge concluded that it was unfair to require direct policyholders who had bought insurance policies designed to transfer to insurers the risk of exposure to (in this case, asbestos) claims to have that risk (of claims arising in the future) compulsorily transferred back to them.

It is this comment (albeit not binding), that it may be unfair for a solvent insurance company to promote a scheme of arrangement involving direct policyholders' IBNR claims, that could be the most significant for the market. If it is not overturned on appeal, it will make it more difficult for solvent insurers to use schemes of arrangement to terminate their books of direct business.

It is not yet known whether BAIC will appeal. Leave to appeal has been granted. Should it do so, the outcome will be of great interest to many in the industry.