UK: Hawk Insurance Company Limited - Court Of Appeal Judgment

The scheme of arrangement is a procedure under s425 of the Companies Act 1985 for obtaining court approval for compromises or arrangements between a company and its members or creditors. Essentially, a scheme can be used to bind a minority of creditors or members, as the court can sanction a scheme once it has been approved by a majority in number representing 75% in value of the class of creditors or members in question. Schemes with shareholders are often used in takeovers as an alternative to the tender offer procedure. Schemes with creditors are frequently used as a restructuring tool - they have become popular in the insurance industry and are becoming increasingly useful in European high-yield debt restructuring. There are some complex technical issues which arise on schemes. One in particular is the question of when creditors should be put in different classes for the purposes of voting on the scheme. This question has recently been considered by the Court of Appeal.

1. On 23 February 2001 the Court of Appeal handed down its judgment in the case of Re Hawk Insurance Company Limited. The case was an appeal from a decision of Arden J (as she then was) declining to sanction a scheme of arrangement that had been proposed by the company on the basis that the meetings of creditors called to approve the scheme had not been properly constituted. The creditors had been placed in a single class despite the fact that the valuation mechanism employed would have treated different types of claim in different ways.
2. The Court of Appeal allowed the appeal, holding that the judge was wrong in holding that the hawk creditors should not have been placed in a single class. The question of whether creditors should be divided into classes depended on whether their rights were so dissimilar that they would be unable to consult together with a view to their common interest. In this case, the common interest was an interest shared by all creditors in an orderly and efficient closure of the estate.
3. The decision is welcome in that it clarifies the precise legal test that must be applied to the issue of creditor classes after some uncertainty. It is likely to prompt a review of the procedure in the Companies Court for obtaining sanction of a scheme of arrangement, which we consider would be helpful. It may also act as an incentive to the FSA to resurrect some of the suggestions put forward in the DTI’s 1994 Consultation Paper on Insolvent Non-Life Insurance Companies for the statutory run-off of this type of company.
4. However, there is still uncertainty left in this area. The creditors in Hawk approved the scheme unanimously, which was clearly a factor in the court’s thinking. It was suggested that the decision might have been different had there been opposition from one or more creditors.
5. Caution will still be necessary where there is the possibility of dissension amongst creditors. Companies who are considering proposing a scheme should take great care, ideally with the benefit of expert advice, to ensure that creditors are classified correctly on the Hawk test.

Hawk was a small motor insurance company that for several years had underwritten a non-life book including liability insurance. They had gone into run-off in 1976 and in 1995 Chris Hughes and Philip Singer from PricewaterhouseCoopers were appointed as provisional liquidators. The scheme of arrangement developed for Hawk was a valuation scheme providing a once and for all estimation of liabilities which would not mature so as to crystallise balances and bring the company’s run-off to an early conclusion. In many respects the Hawk scheme followed earlier valuation schemes – mainly ScotCom and Osiris. However, unlike Scotcom, Osiris and Trent the Hawk scheme contained a claims valuation process under which creditors were invited to come forward with the details of their claims, subject to agreement, but would be paid dividends on the basis of a valuation of 100% of paid claims, 75% of outstanding losses and 50% of IBNR claims. In the absence of agreement, claims were to be referred to a scheme adjudicator for independent adjudication. What was unusual about the scheme was that paid, outstanding and IBNR were subject to a valuation process applied to all claims as a broad brush approach. There is no doubt that in practice the result of this across the board valuation formula would come close to the results of more specific valuation formulae adopted in earlier valuation schemes; it has been suggested that this is more or less what was achieved on the application of more complex valuation formulae in other schemes.

At the hearing to sanction the scheme in December 1999 Arden J refused to sanction the scheme for two reasons. First, the judge decided that class meetings of creditors for the approval of the scheme were not properly constituted; secondly, the judge objected to the fact that the scheme contained adjudication procedures which excluded all access to the Court. The adjudication point was settled by a further hearing in January 2001 – however, the point on creditor classes required a great deal more attention.

The main point concerning Arden J appeared to be that those whose claims to be valued under the scheme, i.e. creditors with Outstanding Losses and IBNR, should be in a different class or classes to creditors whose claims would not be subject to valuation. Of course, it has been the practice in most valuation schemes to put all creditors into one class on the basis that they are all affected, although to a greater or lesser extent, by valuation. In one of the most recent solvent schemes – Osiris – a single meeting was held. This case was reviewed by Arden J who recognised that a valuation scheme had been approved by creditors without the need to convene several meetings of creditors with paid, outstanding or IBNR claims. Arden J distinguished the case on two grounds: first, in Osiris, all claims were to be paid in full and the creditors mainly had claims made policies with short tail risks. Most claims ought to have been notified to the company before the date of the scheme. Hawk was different since it did have long tail business on occurrence basis, so more creditors included IBNR; and second, the definition of scheme claim in Osiris was confined to claims in relation to contracts for insurance or reinsurance. In Hawk all claims howsoever arising, including, for example, claims of brokers in relation to unpaid commission were included within the class.

In a very crude sense, one can conclude that within the class there were on the one hand creditors who had an interest in seeing the valuation process produce as low a result for the insurance creditors as possible (as such creditors had claims which were simply not subject to valuation) - and on the other hand creditors who were interested in seeing a much higher result arise from valuation. The creditors clearly have a different interest - does this produce different rights?

Arguably it does since it will only be certain creditors within the class whose rights are subject to valuation. Critically, Arden J said, unlike the scheme in Osiris, creditors are to be treated differently under the Hawk scheme for distribution purposes:

For this reason the scheme was not sanctioned at first instance, and an appeal was necessary.

The leading Judgment in the Court of Appeal was given by Chadwick LJ – he had heard an application for leave to appeal in re BTR plc, to which we shall return shortly. Chadwick LJ started by reviewing the procedure leading up to the hearing for sanction. A key point in Chadwick LJ’s analysis was his view that, where there are distinct classes of creditors in a scheme, what the court is actually looking at is a number of different arrangements. They may be linked, and mutually dependent, but the true analysis is that each is a separate arrangement between the company and the class of creditors in question. The court agreed with the trial judge in her construction of s.425 – i.e. that the question is one of jurisdiction, where the court’s power to sanction the scheme did not arise at all until the properly constituted meetings of the classes of creditors had approved the scheme. The court went on to make some interesting observations as to the present Companies Court practice. Chadwick LJ went back to the 1934 Practice Note, which puts the responsibility for convening correctly constituted class meetings firmly on the company, saying that the company must run the risk of the scheme being thrown out if it gets it wrong.

Chadwick LJ’s view was "an applicant is entitled to feel aggrieved if, in the absence of opposition from any creditor, the court holds, at the third stage and on its own motion, that the order which it made at the first stage was pointless. It is to my mind, no answer to say that that is a risk which the applicant must accept. It may be inevitable that an applicant must accept the risk that a dissenting creditor will persuade the court at the third stage that the order which it made at the first stage (without hearing that creditor) was the wrong order, but that is not to say that the applicant must be required to accept that, when exercising what is plainly a judicial discretion at the first stage, the court will not address the question whether the order which it makes serves any useful purpose; or that, if it has addressed that question at the first stage, it will change its mind of its own motion, at the third stage………I draw attention to the position because it has led to delay and expense which could have be avoided; and because I think that the existing practice merits re-examination."

Clearly, the Companies Court is going to have to give some thought to the procedure for obtaining sanction for a scheme of Arrangement in light of the above comments. We will discuss the action that might be taken below.

The Court of Appeal in Hawk went on to consider the question of how one goes about dividing creditors into classes. For Chadwick LJ, the starting point was to consider whether the true analysis of the scheme proposed was that it was a number of linked arrangements between the company on the one hand and its various classes of creditors on the other. The court returned to its decision in Sovereign Life Assurance Company v Dodd. As this was the only decision binding on the Court of Appeal in Hawk, Chadwick LJ gave detailed consideration to that decision. However, the key statement, which can be found in the Judgment of Bowen LJ, is that a class of creditors is a group comprising "those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest."

In fact, Dodd was not a decision on whether a scheme should be sanctioned. In that case, Dodd was a policyholder of Sovereign Life who had also borrowed money from Sovereign Life secured on the policies. He sought to set off the full amount of the policy against the loan – this would have been of greater benefit to him than a payment of the reduced sum that would have been payable under the scheme in that case. Apparently, no point on whether there may have been an automatic set-off on the making of the Winding Up Order was taken. The question before the Court of Appeal in Dodd was whether under the scheme as sanctioned, the Defendant was obliged to release his right of contractual set-off as between the policy and the loan. The court held that, the policies having matured, a sum was due to Dodd from Sovereign Life and there was an existing right of set-off available to him at the time the Deed of Arrangement was approved. On the face of the Deed, there was no release of this right to set-off. As Chadwick LJ noted, that was all the Court of Appeal needed to decide. However, the discussion in the case does bring in broad notions of whether the Defendant should have been placed in a particular class had he attended any meeting or meetings. For this reason, the Judgment has subsequently been taken as authority for the proposition that creditors whose rights have vested must always be a different class to creditors whose rights will not vest until some time in the future. It has also been cited, particularly in Buckley, to support the view that holders of matured policies from an assurance company are always in a different class to holders of current policies. In Chadwick LJ’s view, Dodd is not authority for either of these propositions. The decision is only binding to the extent that it holds that a creditor who has an existing right of set-off against a company is not to be placed in the same class as creditors of that company who did not have that right. Had the point been in issue, the Court of Appeal in Dodd might have found that holders of matured policies did indeed constitute a different class to those whose policies had not matured – but that would have been because the scheme substituted different rights for creditors who had policies which had matured. This does not necessarily mean that they would have been in different classes in all cases , and with respect to all proposed schemes. To determine whether different classes are created, there must be an analysis of the rights which the creditors hold immediately before the scheme and a comparison with the new rights (if any) which the scheme gives to the holders of those rights. The basic test taken from the Judgment of Bowen LJ in Dodd has been applied on numerous occasions at first instance in England and elsewhere throughout the Commonwealth. The Court of Appeal in Hawk did not go into detail on any of these decisions, apart from a brief quotation from an Australian decision, Nordic Bank plc v International Harvester Australia Limited & Anor.

The Judgment of Mr Justice Lush which is quoted in Hawk makes two important points: First, the comparison between creditors’ positions must always be in the context of "interests related to the company and its scheme"; second, the court must be careful to avoid requiring creditors to be divided into classes to such a degree that the majority provisions of s.425 become meaningless – there may well come a point where a minority with some interest not connected to the company and the scheme may be given an effective veto over the entire scheme. Chadwick LJ had previously noted in BTR that the sanction hearing is an opportunity for the courts to consider whether there has been any majority oppression at the creditor meetings. The reverse is also true – the meetings must not allow there to be oppression by a minority either.

Applying the test extracted from the authority to the facts of Hawk, the Court of Appeal held that it was indeed appropriate for all creditors to be placed into a single class. The starting point was to consider the rights enjoyed by the creditors immediately prior to the scheme. In fact, the company was clearly insolvent at that time. Therefore, the rights enjoyed by the creditors were essentially rights to prove for debts in a liquidation. In the case of creditors who had claims in respect of outstanding and IBNR losses, the right to prove in liquidation was a right to have the company’s exposure valued and admitted. However, this was not a question of there being a difference between the creditors’ rights; the difference was in giving effect to the rights of creditors whose claims were unliquidated at the time of ascertainment. The Court of Appeal heard further evidence (which was not produced to the trial judge) as to what would have happened had Hawk gone into liquidation. Broadly, the company carried on general rather than long-term business; the claims in question arose out of long-tail occurrence policies, generally relating to industrial diseases and environmental liabilities, all of which had expired; and, critically it would appear, any given policy could give rise to any combination of paid claims, outstanding losses or IBNR losses. In this context, the weighting provisions in the Hawks scheme did not reflect any difference in the rights of creditors, but reflected their common interest in having a just and fair valuation mechanism similar (if not identical) to having a "just estimate" of the value of the claim in liquidation.

Returning to the Bowen LJ test, in Chadwick LJ’s view "neither the rights released or varied, nor the new rights given under the scheme, are so dissimilar as to make it impossible for the persons entitled to those rights to consult together with a view to their common interest. The common interest, in the present case, is in achieving a relatively simple, inexpensive and expeditious winding-up of the company’s affairs outside a formal liquidation." On this basis the Court of Appeal felt able to sanction the scheme.

So where does this leave us? Recent authority, particularly BTR, has tended to suggest that the question of dividing creditors into classes depends on their rights. However, it is now clear that it is too simplistic to say simply that creditors with the same rights are in one class and creditors with different rights must be in different classes. For example, in the market companies have frequently put protected policyholders into a different class to non-protected policyholders. Two creditors might have identical claims for identical sums arising out of identical policies on the same book of business, but if one of them is a UK individual, and the other is a company, they will find themselves in different classes on this approach, even though their rights against the company are identical. The reason for this is that the scheme (on the assumption that the PPB are participating) will affect the rights of those creditors in different ways. The individual will receive a payment of 90p in the £ from the PPB, whilst the company is left to take its chances under the scheme. As such, they do not have a common interest in the outcome of the scheme. Taking a further example, consider on the one hand a creditor who is owed £1,000 on a direct insurance policy and, on the other, a creditor who is owed £10 million on a reinsurance contract. Although their rights are different and have arisen in different ways, and they are likely to have very different commercial interests, if the scheme treats their rights in broadly the same way, they may well find themselves in the same class. What the court is looking for are "dissimilar interests related to the company and its scheme" in Mr Justice Lush’s words in Nordic Bank; indeed, turning once again to the key sentence from Bowen LJ, as approved by Chadwick LJ, saying a class "must be confined to those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest" clearly contemplates that creditors whose rights are different may well find themselves in the same class.

As noted at the outset, the court also questioned the practice adopted under s.425. Although reference is made to the 1934 Practice Note, the hands of the court are really tied by the language of s.425. On construction, the court cannot do anything until it is presented with a scheme which has been approved by the appropriate classes of creditors. If there had been serious class questions in Hawk, then the Court of Appeal would have found it very difficult to sanction the scheme. In fact, the creditors in Hawk passed the scheme unanimously, and even the Judge at first instance recognised that there were strong commercial reasons and favoured the scheme. Looking at the Judgment of the Court of Appeal closely, the court took a very broad view of what the creditors’ "common interest" actually was, and drew comfort from the fact that the creditors themselves had demonstrated what their common interest was in their unanimous approval of the scheme. It would be preferable to receive directions from the court at the time leave is given to convene meetings as to what meetings should actually be convened – this will front-end some of the expenditure and investigation that has to be incurred and carried out, but this is surely preferable to having that time and money completely wasted if a scheme is thrown out at a sanction hearing. However, the crux of the problem is really the decision that class issues go to jurisdiction rather than discretion. In the light of the confirmation of this point by the Court of Appeal in Hawk, softening its effect would require amendments to s.425. This technical point has resulted in the Hawk scheme (and, presumably, many similar schemes that were in the drafting stages) being delayed by nearly 18 months despite the fact that all parties concerned (including the Judge) saw the good commercial reasons for implementing it. If the question of creditor classes went to discretion rather than jurisdiction, then the commercial justifications for the Hawk scheme, together with its unanimous approval, would surely have outweighed the class points in the exercise of the Judge’s discretion. The court would still be performing a substantive role in its checking of the scheme and the meetings for any oppression (as described in BTR). However, in light of the interpretation of s.425 by the Court of Appeal in Hawk, class issues will remain a matter of absolute jurisdiction until the legislation is changed. The next Court of Appeal decision on s.425 is likely to be one brought by a minority of creditors who were out-voted at a scheme meeting, and who claim that they should have been in a separate class. There will remain a measure of uncertainty until then. Although other reform measures in the field of insurance insolvency are proposed – particularly the possible lifting of the bar on entry into administration that currently exists for insurance companies – the s.425 scheme is likely to remain one of the preferred routes for insurance run-off for the foreseeable future. Whilst the decision of the Court of Appeal in Hawk is welcome, the law, not to mention the practice of the Companies Court, in this area still needs a measure of reform.