What is a Scheme of Arrangement ?
A Scheme of Arrangement is a compromise or arrangement between a company and its creditors (or any class or them), governed by Section 411 of the Corporations Act 2001 in Australia or section 425 of the Companies Act in England. Such a Scheme essentially sets out the rules by which the administration of the company will be governed.
The Schemes of Arrangement are administered separately, but parallel to, the Liquidations of the Scheme Companies. Instead of dealing with the Liquidators, the affairs of creditors will now be handled by the Scheme Administrators. The Scheme Administrators of the Australian Schemes are Mr A G McGrath and Mr J Preston of McGrathNicol and the Scheme Administrators of the English Schemes are Mr B J Gale and Mr M S Walker of KPMG LLP (UK).
Benefit of a Scheme of Arrangement
The Australian Liquidators and English Provisional Liquidators see the main benefits of the Schemes as:
1. More efficient claims agreement - Insurance claims against the company will be agreed and recorded as they would within the operation of a solvent insurance company. The formal proof of debt procedure normally required under the law is not required under the Schemes.
2. Earlier final closure - The Liquidators have determined that if the Liquidations were to continue without the aid of a Scheme they would continue for 20 years or more in order to protect the interests of creditors with "long tail" insurance claims. Long tail claims occur where claims are made against a policy even if the coverage period itself is long since past. Examples of long tail business include public liability and professional indemnity cover. The Schemes include an estimation mechanism where creditors with potential claims not yet agreed will receive a scheme payment based on an actuarial estimate of their claim after 8 years. This estimation procedure enables all creditors to receive final payments significantly sooner than would be possible under liquidation alone.
Interpretation of Australian Legislative Priorities
All liquidations in Australia (whether insurance companies or not) are subject to distribution priorities set out in the Corporations Act. These priorities are similar to the kind of priorities in other countries. However, two additional sections of Australian legislation apply when an insurance company is placed into liquidation in Australia. These sections are section 562A of the Corporations Act, and section 116(3) of the Insurance Act.
Section 562A contains special provisions which detail the priorities which apply to reinsurance recoveries made by a liquidator. Section 116(3) overlays a restriction on top of all of the other priority provisions. Section 116(3) provides that the liquidator of an Australian insurance company should not distribute any of the Assets in Australia other than in payment of the Liabilities in Australia, unless the Liabilities in Australia have been paid in full.
The effect of the Australian legislative priorities is that creditors whose claims are classified as Insurance Liabilities have a potential advantage over creditors whose claims are not classified as Insurance Liabilities, and creditors whose claims are classified as Liabilities in Australia have a potential advantage over creditors whose claims are not classified as Liabilities in Australia.
The Australian Scheme adopts the following approach:
• The Australian legislative priorities that would apply in an Australian liquidation will apply to all assets worldwide which can be realised by the Liquidators or the Scheme Administrators (other than US Trust Fund Assets) for distribution in accordance with those priorities
• Where the liquidators or Scheme Administrators are prevented from realising assets located in foreign jurisdictions and distributing them in accordance with the Australian legislative priorities, it may be necessary to implement separate schemes of arrangement or other insolvency proceedings in those jurisdictions. This is no different to the situation that would apply if the Australian Scheme companies were to remain in liquidation; and
• Any amounts released to the Scheme Administrators from the US Trust Fund Assets by the Superintendent of Insurance for the State of New York will be distributed, after payment of the Scheme Administrators reasonable and necessary expenses in causing the distribution of the US Trust Fund Assets, pro rata to the specified beneficiaries of the US Trust Fund Assets (who are defined in the related trust agreements as ”American Policyholders”) after adjusting for any payments Scheme Creditors have received from all other sources.
The Australian Scheme does not alter any of the priorities which would apply in the distribution of any of the assets which would be available to the liquidators in the Australian liquidation. The Australian Scheme reflects what would happen to those assets in the Australian Liquidation.
In order to give effect to the Australian priority sections, the Liquidators would have to divide the assets available to them into four categories. A further category is required to distribute US Trust Fund Assets. The relevant Australian Scheme clauses, outlining the four categories of assets necessary to give effect to the Australian legislative priorities are listed below, together with the clause detailing the priorities to apply the US Trust Funds:
• Clause 31 Reinsurance Assets that are Assets in Australia
• Clause 32 Reinsurance Assets that are not Assets in Australia
• Clause 33 Non Reinsurance Assets in Australia
• Clause 34 Non Reinsurance Assets which are not in Australia
• Clause 35 US Trust Fund Assets
The distribution of the Scheme Assets has been designed taking into account the guidance received in a recent judgement by the Court in HIH Casualty & General Insurance Ltd  NSWSC 240; (2005) 53 ACSR 12.
For further information and explanation refer to Section 5: Distribution Priorities of the Australian Explanatory Statement.
Interpretation of English Distribution Priorities
The effect of the Australian legislative priorities is that creditors whose claims are classified as insurance liabilities have a potential advantage over creditors whose claims are not classified as insurance liabilities, and creditors whose claims are classified as Liabilities in Australia have a potential advantage over creditors whose claims are not classified as Liabilities in Australia. By comparison, for any liquidation of an insurance company which commenced in England prior to April 2003, the claims of all unsecured creditors worldwide rank pro rata in the distribution of assets (after provision for some particular priorities such as costs and employee claims). No distinction is made as to where the assets or liabilities are located. It is these differences in the English legislative distribution priorities when the compared to the Australian legislative distribution priorities, which led the English Court to order that the English assets of the English Scheme Companies should not be remitted to the Australian Liquidators by the English Provisional Liquidators.
In December 2004 the Australian Liquidators of the HIH companies applied to the Australian Court for an order to convene meetings of creditors to consider proposed schemes of arrangement to deal with distribution of all of the assets of each of the main licensed insurance companies in the group. The intention in the proposed schemes was to apply the Australian legislative distribution priorities to most assets, but to apply the English legislative distribution priorities to the assets in England. The proposed schemes were developed in co-operation with the English Provisional Liquidators.
A number of Australian creditors objected, arguing that the Australian priorities should be applied to all assets, including the English assets.
To resolve this issue the English Provisional Liquidators applied to the English Court for directions as to whether the assets they control should be released to the Australian Liquidators or not. The Australain Liquidators opposed the English Provisional Liquidators in the proceedings to ensure that the issues were fully tested. Several Australian creditors also opposed the English Provisional Liquidators.
The case was heard in July 2005 and judgement given on 7 October 2005 — In the matter of HIH Casualty and General Insurance Limited & Ors  EWCH 2125 (Ch). Mr Justice David Richards concluded that an essential element of the principal in Re BCCI (No 10)  Ch 213 is that the scheme for distribution in the jurisdiction of the principal liquidation must provide for pari passu distribution substantially the same as under English Law. In the absence of that, the English Liquidator’s role in the ancillary liquidation was not restricted to collection of assets and settlement of lists of crditors — the English liquidator would be obliged to distribute the funds held to creditors worldwide on the basis of the English statutory priorities.
Mr Justice David Richards ruled that the assets in England should not be transmitted to the Australian Liquidators for Distribution in accordance with the Australian legislative priorities as it would involve a materially different basis for distribution than would apply in an English Liquidation.
The decision therefore leaves the current position in relation to the English Schme as follows:
• In an English Liquidation of the English Scheme Companies, the English legislative priorities would apply, as ruled by Mr Justice David Richards
• The Decision of Mr Justice David Richards was appealed, The Court of Appeal upheld his judgment and a further appeal to the House of Lords is due to be heard in December 2007, with judgment expected during 2008.
• The English Schemes provide alternatives, to accommodate the final outcome of the appeals:
• first alternative: if the appeal is unsuccessful, the English Assets (after costs and the preferential debts set out in section 386 of the Insolvency Act) will be distributed pro rata to all unsecured creditors worldwide, after adjustment of creditor entitlements to allow for any recoveries made by creditors from other sources (such as distributions by the Australian Scheme Administrators);
• second alternative: if the appeal is successful and the English Scheme Administrators or English Provisional Liquidators are ordered to release the assets for distribution in accordance with Australian legislative priorities, the English Assets will be released for distribution in accordance with the Australian Scheme. This would be subject to any conditions attached to the English Court Order, such as payment of English priorities such as costs and employee entitlements.
If neither of the above alternatives apply, the English Schemes provide that the English Scheme Administrators may at their discretion adjust any future distributions or payments in accordance with the order of the Appeal Court; or apply to the Court for leave to convene a creditors meeting in order to amend the English Scheme to comply with the order of the Appeal Court; or terminate the English Scheme with a view to the English Scheme Company continuing to run-off in provisional liquidation.