Australia: Getting your priorities right: Sydney Water Corporation v McGrath [2014] NSWCA

Sydney Water Corporation v McGrath [2014] NSWCA 197

Intoduction

A recent judgment of the New South Wales Court of Appeal helpfully illustrates the operation of the priority in relation to reinsurance proceeds under ss 562A(4) of the Corporations Act 2001 (Cth). The decision provides an example of when a court will reject a creditor's application for priority in the distribution of an insolvent insurer's reinsurance proceeds. The decision also provides a useful contrast to the Amaca¹⁵ decisions, where similar applications were granted, and thus assists in identifying where the line is drawn in such applications.

The source – section 562A

Section 562A governs a liquidator's obligations regarding the distribution of money received under a contract of reinsurance. If the amount received by the liquidator is greater than the total amount payable by the company under contracts of insurance, the liquidator must pay all such insurance creditors in full (ss 562A(2)). If the amount received is less than that payable, each insurance creditor partakes of the reinsurance recovery pro rata in a proportion equivalent to their share of the total amount owed to all insurance creditors (ss 562A(3)) ¹⁶.

However, ss 562A(4) establishes a "cut-through" mechanism permitting reinsurance proceeds to be distributed in some other way sought by an insurance creditor. In considering an application under ss 562A(4), the Court must consider that the alternative sought is "just and equitable in the circumstances". Subsection 562A(5) lists factors that the Court may consider in determining whether such an order is just and equitable.

The waters are agitated

Before their liquidation, the HIH Group of Companies (HIH) owed money to Sydney Water Corporation (SWC) in respect of an insurance claim in connection with a water contamination incident. SWC had already received approximately $2.5 million, with its subsequent claims in the winding up acknowledged to total approximately $7.6 million. HIH had, in turn, received funds under a contract of reinsurance with a UK reinsurance syndicate (the Syndicate).

Accordingly, SWC applied under ss 562A(4) for an order that it receive full reimbursement from HIH on the basis that the reinsurance proceeds from the Syndicate be paid with priority in respect of its claim. SWC based its application on the assertion that the relevant reinsurance contract was a direct result of SWC's long-term relationship with the Syndicate. Given the interrelationship between HIH's liability to SWC and the reinsurance contract, SWC submitted that the order sought was just and equitable.

SWC's application was rejected at first instance and SWC appealed.

Stormy waters for SWC

In dismissing the appeal, the Court of Appeal similarly rejected SWC's application. Barrett JA (with whom Ward JA agreed while MacFarlan JA dissented) held that the trial judge had not erred in finding no extraordinary or unusual relationship between SWC and the Syndicate justifying the orders sought.

Barrett and Ward JJA noted several flaws in the evidence adduced by SWC. A November 1995 executive meeting paper, although referring to the importance of developing and maintaining strong working relationships with leading underwriters and reinsurers, did not mention the Syndicate. A post-liquidation letter allegedly supporting the close relationship between SWC and the Syndicate was merely written by SWC's broker. Furthermore, the Syndicate's reply indicated that it considered it inappropriate to be dealing directly with SWC.

A 1997 "selling trip" to London by SWC and HIH employees was considered to be of little consequence. Ward JA pointed out that there were no indications that the trip involved any direct premium negotiations for the 1997 reinsurance program. Barrett JA and Ward JA both emphasised that each party was pursuing its own interests. HIH benefitted from SWC representatives assisting the Syndicate to make informed decisions, SWC benefited by seeking to keep reinsurance (and therefore direct premium) costs in check and strengthening its commercial relationships.

However, ultimately HIH negotiated the reinsurance contract rather than SWC. On this basis it was open for the trial judge to find that the primary purpose of the trip was merely the provision of information. This was considered insufficient to support an order under ss 562A(4), in light of the criteria the Court must take into account under ss 562A(5).

In reference to the broader question of whether it was "just and equitable" to direct the reinsurance funds to SWC as opposed to the broader group of insurance creditors, Barrett JA contrasted the Amaca cases (which he also decided). In those cases, similar orders were granted because:

"in effect, the particular reinsurance was obtained for the express purpose of satisfying the particular insured's needs and it was in fact the reinsurer that met those needs, albeit with the insurer interposed between them." [101]

Barrett JA noted that HIH typically retained 25% of the risk, although MacFarlan JA referred to a lower overall figure in his judgment. Both commented that SWC had an unusual relationship with the Syndicate, although they differed on whether that long-term relationship was sufficiently "extraordinary or unusual".

Ward JA took an even more strident view, considering that attempts by an insured to cultivate a relationship with a reinsurer were not unusual in the least. Neither he nor Barrett JA considered it significant that SWC had input on some policy wording changes. Both held that, in respect of the Syndicate, HIH was not simply a front or conduit for SWC.

SWC's application therefore foundered.

The wash-up

This decision clarifies the extent to which an applicant must be able to demonstrate an "extraordinary or unusual" relationship with a reinsurer so as to justify priority in respect of reinsurance proceeds. Whether insured, insurer or reinsurer, it is important to be aware that merely attempting to develop a business relationship or the provision of information is unlikely to support such orders. Accordingly, the decision assists in setting the watermark (which is seemingly quite high) for applications under ss 562A(4).