Meltdown at Lloyds A Few Topical Issues

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Sep 2004

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The legal know-how
required to manage an orderly meltdown of the heterogenous, intensely
abstruse Lloyd's enterprise has not yet been developed. The auspices
are not good. Specialist insurance lawyers do not even use relevant
elementary legal terminology correctly. For example, the pandemic notions
that Lloyd's sells insurance, or that a syndicate at Lloyd's
sells insurance, are based on the misunderstanding of the true nature of
Lloyd's (a mere corporation<a href="#1" name="1a">1</a> that does not sell insurance) and
the true nature of syndicate-year-of-account participation.

<h4>Reprieve for the Lloyd's Enterprise</h4>

The need to address enterprise-level meltdown
scenarios—and not just in anticipation of years of well-paid claims
litigation—was first seriously mooted in 1995-96 when numerous
components of the Lloyd's enterprise, including Lloyd's itself
(properly so-called), were insolvent, principally on account of
asbestos-related liabilities contracted in underwriting years before 1993.
In the 1996 back-office exercise at Lloyd's known as
"Reconstruction and Renewal" (R&R), the then-U.K.
insurance regulator, the Department of Trade and Industry,
agreed—subject to conditions, some of which remain secret<a href="#2" name="2a">2</a>—that
the Lloyd's enterprise could erase all those liabilities from its
balance sheet simply by buying outward reinsurance from a reinsurance
company, Equitas Reinsurance Ltd., which was capitalised virtually entirely
by money already in or subject to the control of the Lloyd's
financial system. The reinsurer thus brought to the table no money that was
not already available within the Lloyd's financial system—and
already adjudged inadequate—to pay relevant liabilities.

As part of R&R, the outwardly reinsured
liabilities appeared to depart the Lloyd's enterprise to Equitas Re,
and the enterprise was thereby restored to apparent sound financial health.
Since 1996, the apparent extrication has enabled the Lloyd's
enterprise to continue doing business as usual as if solvent, as if those
liabilities had never existed, and as if the enterprise's insistent
blandishments about policyholder security at Lloyd's had never been
made. As then New York Superintendant of Insurance, Ed Muhl, pointed out at
the time, the alternative was too bleak to contemplate.<a href="#3" name="3a">3</a>

<blockquote><blockquote>
<hr>
<big><center>
The phenomenon of Equitas Re should occupy U.S.
malpractice courts and legal psychologists for years to come.
</center></big>
<hr>
</blockquote></blockquote>

<h4>Reprieve Revisited</h4>

Recently, the Financial Services Authority
(FSA)—a U.K. insurance regulator—has reconsidered, to a small
but significant degree, its rule<a href="#4" name="4a">4</a> empowering the Lloyd's enterprise
to take unconditional 100 percent balance sheet credit for Equitas Re
outward reinsurance. For as long as Equitas Re remains regulatorily
solvent, those liabilities will soon be expressly liable to return to the
Lloyd's enterprise's balance sheet as contingent liablities.<a href="#5" name="5a">5</a> If
Equitas Re (more on this later) is to be taken at its insistent word that
it is impecunious and bound shortly to become formally insolvent,
presumably insurance insolvency lawyers will begin to appreciate that the
liabilities merely outwardly reinsured by Equitas Re will rebound as
actual, current liabilities right back to the Lloyd's enterprise.
Equitas Re's own dire predictions, plus the forthcoming change of
accounting emphasis, are already leading a few lawyers to revisit the need
for that legal know-how.

<h4>EU Law Needs Implementing</h4>

Meltdown technology happens also now to be in the
forefront of the mind of the U.K. Treasury (<a href="http://www.hm-treasury.gov.uk">http://www.hm-treasury.gov.uk</a>), yet another U.K. insurance regulator, because of a recent
EU directive, Council Directive 2001/17/EC (March 19, 2001) on the
reorganisation and winding-up of insurance undertakings. The directive does
apply (though not specifically enough to be of any illumination) to
underwriters at Lloyd's as well as to conventional insurers
throughout the European Union. The United Kingdom has already implemented
the directive<a href="#6" name="6a">6</a> in relation to conventional insurers within its
jurisdiction, but expressly<a href="#7" name="7a">7</a> not in relation to underwriters at
Lloyd's, principally because the Treasury had no idea how to do so.
The Treasury is now more than a year late in implementing the directive in
relation to the Lloyd's enterprise and has yet to issue even a
consultation paper on the subject. When eventually published, the
consultation paper will give the first indication in the 300-year history
of the Lloyd's enterprise of the legal approach appropriate under
English law when Lloyd's collapses.

<h4>What of Equitas Re?</h4>

The phenomenon of Equitas Re should occupy U.S.
malpractice courts and legal psychologists for years to come. The 1996
plain-vanilla, back-office outward reinsurance from underwriters at
Lloyd's to Equitas Re appears to have convinced significant portions
of corporate America and their lawyers, without seeing any probative
documents (there aren't any), that the cedant underwriters have been
not merely outwardly reinsured but utterly extricated from their insurance
liabilities. U.S. Lloyd's policyholders appear to have been easily
persuaded by Equitas Re—even in its overt capacity of claims handling
agent for Lloyd's underwriters—to accept materially less than
100 percent of their valid claims, and to sell back insurance contracts not
yet matured into claims. Some U.S. Lloyd's policyholders have even
sued Equitas Re in various U.S. jurisdictions as an assumption reinsurer.

Equitas Re's formal insolvency is likely to
precipitate a more careful examination by relevant U.S. Lloyd's
policyholders of their recourse rights at Lloyd's, and an increasing
appreciation of the various claims payment securitisation trust and other
funds that have always been available to pay qualifying claims 100 percent
and that continue to be protected by the negotiating strategies of Equitas
Re, the silence of insurance regulators, the operational techniques of
Lloyd's brokers and the "expert" advice of the
claimant's own lawyers.

<h4>More Local Insolvency</h4>

Insurance at Lloyd's is conducted by
individuals, natural or corporate—any of whom could become insolvent
at any time. At least in ordinary circumstances, a relevant Lloyd's
policyholder's right to recourse to relevant claims payment
securitisation trust funds is independent of a Lloyd's
underwriter's personal financial condition. How an insolvent
underwriter wraps up its financial affairs is therefore of no concern to
the Lloyd's policyholder or, indeed, to any insurance regulator.
Consideration is increasingly being given to wrapping up a solvent and
insolvent corporate Lloyd's underwriter's affairs using a
Companies Act 1985, s.425 scheme of arrangement.'

<h4>Companies Act 1985, s.425 Scheme of Arrangement</h4>

The "scheme of arrangement" device
available under Companies Act 1985, s.425<a href="#8" name="8a">8</a> enables a solvent or insolvent
debtor "company",<a href="#9" name="9a">9</a> in certain circumstances and subject to
certain conditions, to devise and implement a payment methodology with its
creditors. The section builds on the general freedom a solvent or insolvent
company has, in principle, under English law to propose a compromise or
arrangement with its creditors. A s.425 scheme has five components: (1) the
company devises a scheme; (2) the court has a discretion to order the
holding of a creditors' meeting to discuss the scheme; (3) creditors
have the opportunity to vote on the proposed scheme at the meeting; (4)
after the vote, the court has a discretion to sanction the scheme; and (5)
if sanctioned, the scheme is implemented.

The scheme device, which includes various types of
share capital reorganisation<a href="#10" name="10a">10</a> and transfers to another company,<a href="#11" name="11a">11</a> is
available only to a "company"<a href="#12" name="12a">12</a> liable to be wound up under
Companies Act 1985.<a href="#13" name="13a">13</a> Since none is a s.735 "company", the
following cannot be schemed: a natural Lloyd's underwriter,
Lloyd's itself,<a href="#14" name="14a">14</a> a syndicate (a mere entrepreneurial idea in
the mind of a managing agency at Lloyd's) and the "syndicate
year of account" device through which Lloyd's underwriters sell
insurance (however corporate the latter's participant(s)).

The scheme device—sometimes suspected by U.S.
insolvency lawyers confounded by such an ostensibly pain-free and
potentially "lawyer-lite" path to release—is congenial to
a debtor, solvent or insolvent, wishing to gather in and discharge all
relevant debts by a certain date, thus achieving certainty of time. It can
be useful for an insolvent debtor constrained to discharge its liabilities
at less than 100 percent, the putative scheme administrator using
commercial sense and sectoral experience in positing to creditors and the
court a rational way to ascertain, marshall and distribute the
company's estate.

Where the company is insolvent, a s.425 scheme can
either stand alone or (more usually) be the means of consummating another
insolvency process such as provisional liquidation,<a href="#15" name="15a">15</a> or actual liquidation<a href="#16" name="16a">16</a>—indeed,
on the liquidator's or administrator's own application to the
court.<a href="#17" name="17a">17</a> A scheme lends itself to being tailored to the debtor
company's particular circumstances, and special types—viz., "cut-off",
"reserving" or "hybrid"—have evolved
specifically for insurance companies.

<h4>Not an "Insurer"</h4>

A corporate Lloyd's underwriter (including a
foreign one<a href="#18" name="18a">18</a>), being neither a statutory "insurer" nor an FSA
"insurer", appears to be free to construct a s.425 cut-off,
reserving or hybrid, solvent or insolvent, scheme in relation to its
relevant liabilities free of all insurer-peculiar statutory and
FSA-regulatory provisions, and to choose not to discriminate, for class or
other purposes, between insurance and general assets and liabilities.
Similarly, there appears to be no law preventing a natural Lloyd's
underwriter from scheming his insurance liabilities via an appropriate
corporate vehicle. And what can be done at the level of sole Lloyd's
underwriter can in principle equally be done—though it is an
increasingly intricate and disruptive<a href="#19" name="19a">19</a> practical and professional<a href="#20" name="20a">20</a> undertaking—at
the level of (among others) all participants on a particular syndicate year
of account, and all participants on a particular insurance slip.

<h4>The Bucket Company</h4>

Creating a properly authorised and certified<a href="#21" name="21a">21</a>
bucket company as a repository for the relevant liabilities (divided, if
appropriate, into classes<a href="#22" name="22a">22</a>) of one or more Lloyd's underwriters<a href="#23" name="23a">23</a>
(presumably at least at stamp level)—query if the device works
equally at syndicate or slip level—is apparently the subject of
current discussions in the London market. The liabilities would be formally
transferred<a href="#24" name="24a">24</a> by a lone transferor, acting on behalf of the Lloyd's
underwriters<a href="#25" name="25a">25</a> concerned, presumably appointed by the Council of
Lloyd's<a href="#26" name="26a">26</a> (among other customised modifications<a href="#27" name="27a">27</a>)—to the
bucket, enabling any corporate Lloyd's underwriter transferee to be
then wound up and dissolved, and only then would relevant creditors be
invited to vote<a href="#28" name="28a">28</a> on it. Query what would happen if they did not approve
it. Before the vote, the usual due diligence must be performed to identify
and flush out all creditors and liabilities, a particularly intricate
exercise at Lloyd's. Highlighting the potential difficulties is the
fact that discharge of an insurance liability in the front office has no
effect whatever on the continuing existence of the Lloyd's
underwriter's various back-office contractual and trust-deed
financial obligations, including to make payment to common funds for the
discharge of other Lloyd's underwriters' relevant liabilities.
Exhaustive due diligence would have to be timeously performed on every
relevant instrument, including in order to ascertain the mechanics of
extricating the Lloyd's underwriter from its clutches.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See Lloyd's Act
1871, s.3. <a href="#1a">Return to article</a>

<a name="2">2</a> The
FSA's so-called "scope of permission" notices (which
replaced as of Dec. 1, 2001, the DTI's Notices of Requirements) for
Equitas Re and Equitas Ltd. are not public documents. They presumably
confer some secret privilege or enable the FSA to bestow some latitude in
relation to either company's solvency or insolvency, or require
(without their present knowledge) current members of Lloyd's to
support Equitas Re financially or bail out the Lloyd's enterprise. <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., Commissioner Ed
Muhl, Superintendant of Insurance, New York State Insurance Department, New York Law School Center for International Law Symposium
Implications of the Reconstruction of Lloyd's of London, Nov. 6, 1996 (<a href="http://www.nyls.edu/CIL/lloyds.htm">http://www.nyls.edu/CIL/lloyds.htm<…;): "New York is basically a port of entry of
Lloyd's for the United States because we oversee all the U.S. trusts.
We also control its status as an eligible writer in the U.S. market as well
as in the excess and surplus lines. I asked my senior management if they
realized what would happen if I signed the order. The general answer was
very simply that Lloyd's would be de-accredited. I responded by
saying, 'If I sign this order, the insurance world as we know it
would change.'" <a href="#3a">Return to article</a>

<a name="4">4</a> See the FSA
Lloyd's rulebook, LLD §12.3.3R: "For the purposes of this
chapter, the following liabilities may be left out of account:...(4)
liabilities for 1992 and prior general insurance business reinsured by
Equitas Reinsurance Ltd." <a href="#4a">Return to article</a>

<a name="5">5</a> See FSA consultation paper
04/7, Lloyd's: Integrated Prudential
Requirements, and Changes to Auditing and Actuarial Requirements Including
Feedback on CP178 (FSA, April 30, 2004),
§§2.99-2.100 (p.34; numbers in [ ] editorially added):

<blockquote>
2.99. The liabilities reinsured by Equitas could
potentially affect members of Lloyd's in future, most importantly:
[1] members whose business was reinsured by Equitas remain liable under the
original contracts: Should the reinsurance fail, assets in those
members' premiums trust funds may be used to meet liabilities
reinsured by Equitas; and [2] assets from the joint-asset trust fund
(JATF), a mutual fund which is held in the United States, may be used to
meet liabilities reinsured by Equitas, which U.S. regulators might require
in turn to be replenished by the Society and/or continuing members of
Lloyd's (most but not all of Lloyd's members are exposed to the
JATF). 2.100. In addition, the Society may use its central assets to
support members' losses, in which case the ongoing membership might
be called upon to contribute to replenish the central fund. So, the Society
and all current members have a contingent liability (albeit small in some
cases) which could crystallise should the reinsurance by Equitas fail. We
propose to clarify our rules to distinguish the current concessionary
treatment (which we propose should continue) from the previous (pre-1996)
treatment. So the proposed rules do not require the original business to be
accounted for within Lloyd's, but instead there is a contingent
liability and the value of that liability (if any) would need to be
accounted for in line with GAAP under PRU 1.3.
</blockquote>

See, also, ibid., Annex 8 ("Proposed Changes to Handbook Text"), proposed PRU
§7.7.78R:

<blockquote>
In recognising and valuing a
"member's" liabilities, the "Society" and
"managing agents" may leave out of account the original
liabilities in respect of 1992 and prior "general insurance
business" reinsured by Equitas Reinsurance Limited. 7.7.79G. There is
a contingent liability associated with the reinsurance into Equitas, which
PRU 1.3 requires "managing agents" and the
"Society" to treat in accordance with generally accepted
accounting practice (GAAP). Depending on the circumstances, "managing
agents" or the "Society" may need to disclose or account
for such a liability. <a href="#5a">Return to article</a>

</blockquote>

<a name="6">6</a> See Insurers
(Reorganisation and Winding Up) Regulations 2003 (SI 2003/1102). <a href="#6a">Return to article</a>

<a name="7">7</a> Insurers
(Reorganisation and Winding Up) Regulations 2003, §3. <a href="#7a">Return to article</a>

<a name="8">8</a> Companies
Act 1985, s.425 (so far as presently relevant):

(1) Where a compromise or arrangement is proposed
between a company and its creditors or any class of them, or between the
company and its members or any class of them, the court may on the
application of the company or any creditor or member of it or, in the case
of a company being wound up, or an administration order being in force in
relation to a company, of the liquidator or administrator, order a meeting
of the creditors or class of creditors, or of the members of the company or
class of members (as the case may be), to be summoned in such manner as the
court directs. (2) If a majority in number representing three-fourths in
value of the creditors or class of creditors or members or class of members
(as the case may be), present and voting either in person or by proxy at
the meeting, agree to any compromise or arrangement, the compromise or
arrangement, if sanctioned by the court, is binding on all creditors or the
class of creditors or on the members or class of members (as the case may
be), and also on the company or, in the case of a company in the course of
being wound up, on the liquidator and contributories of the company. (3)
The court's order under subsection (2) has no effect until an office
copy of it has been delivered to the registrar of companies for
registration, and a copy of every such order shall be annexed to every copy
of the company's memorandum issued after the order has been made or,
in the case of a company not having a memorandum, of every copy so issued
of the instrument constituting the company or defining its constitution...
(6) In this section and the next, (a) "company" means any
company liable to be wound up under this Act, and (b)
"arrangement" includes a reorganisation of the company's
share capital by the consolidation of shares of different classes or by the
division of shares into shares of different classes, or by both of those
methods. <a href="#8a">Return to article</a>
</blockquote>

<a name="9">9</a> Per
Companies Act 1985, s.425(6)(a), "company" as used in the
section means "means any company liable to be wound up under this
Act." <a href="#9a">Return to article</a>

<a name="10">10</a> Companies
Act 1985, s.425(6)(b). <a href="#10a">Return to article</a>

<a name="11">11</a> See Companies Act 1985,
s.427. <a href="#11a">Return to article</a>

<a name="12">12</a> Defined at Companies Act
1985, s.735. <a href="#12a">Return to article</a>

<a name="13">13</a> Companies
Act 1985, s.425(6)(a). <a href="#13a">Return to article</a>

<a name="14">14</a> Nor is the
corporation presently included among the other entities (see Enterprise Act 2002,
s.255(1)) to which the Treasury is empowered (by Enterprise Act 2002,
s.255(2)(c)) to extend s.425. <a href="#14a">Return to article</a>

<a name="15">15</a> See Insolvency Act 1986,
s.135; Insolvency Rules (SI 1986/1925 as amended), Part IV, Ch. 5. <a href="#15a">Return to article</a>

<a name="16">16</a> See Insolvency Act 1986,
Part IV; Insolvency Rules (SI 1986/1925 as amended), Part IV. <a href="#16a">Return to article</a>

<a name="17">17</a> See Companies Act 1985,
s.425(1), (2). <a href="#17a">Return to article</a>

<a name="18">18</a> See Re Drax Holdings Ltd; Re InPower Ltd. [2003] EWHC 2743 (Lawrence Collins J). <a href="#18a">Return to article</a>

<a name="19">19</a> At its
most superficial, such a radical reconfiguration of the enterprise would
require the permanent cessation of self-regulators'-at-Lloyd's
insistent blandishments of superior securitisation. <a href="#19a">Return to article</a>

<a name="20">20</a> The
exercise would require, on the professional adviser's part, the
deepest knowledge of all relevant FO-MO-BO, PU and CU aspects of the
Lloyd's enterprise. <a href="#20a">Return to article</a>

<a name="21">21</a> See (for example) FSMA 2000,
s.111(2)(a), read with ibid., Sch. 12, §1(1), etc. <a href="#21a">Return to article</a>

<a name="22">22</a> See Companies Act 1985,
s.425(1) and (2), s.426(1), etc. <a href="#22a">Return to article</a>

<a name="23">23</a> Financial
Services and Markets Act 2000 (Control of Business Transfers) (Requirement
on Applicants) Regulations 2001, §§3, 4(b), 5(a) and 5(b) use the
word "member" infelicitously. <a href="#23a">Return to article</a>

<a name="24">24</a> See FSMA 2000, Part VII, read
with ibid., s.323:

<blockquote>
The Treasury may by order provide for the
application of any provision of Part VII ["Control of Business
Transfers"] (with or without modification) in relation to schemes for
the transfer of the whole or any part of the business carried on by one or
more members of the Society or former underwriting members.

</blockquote>

Read with Financial Services and Markets Act 2000
(Control of Transfers of Business Done at Lloyd's) Order 2001 (SI
2001/3626) (reproduced at Appendix II). Ibid. applies the following to a transfer of liabilities
incurred at Lloyd's: (1) (per ibid., §3(a)) FSMA 2000, ss.104 and 107-114; (2) (per
op. cit., §3(b)) Financial Services and Markets Act 2000 (Control of
Business Transfers) (Requirements on Applicants) Regulations 2001 (SI
2001/3625) (reproduced at Appendix II), as being made under FSMA 2000,
s.108; (3) (per op. cit., §3(c)) FSMA 2000, Sch. 12 ("Transfer
Schemes: Certificates"), Part I ("Insurance Business Transfer
Schemes"). Also see the detailed provisions at SUP, §18.2. <a href="#24a">Return to article</a>

<a name="25">25</a> Financial
Services and Markets Act 2000 (Control of Business Transfers) (Requirements
on Applicants) Regulations 2001, §4(b). <a href="#25a">Return to article</a>

<a name="26">26</a> See Financial Services
and Markets Act 2000 (Control of Business Transfers) (Requirements on
Applicants) Regulations 2001, §§3 and 4(b). <a href="#26a">Return to article</a>

<a name="27">27</a> For
example: (1) per FSMA 2000, s.104, the transfer must be the subject of an ibid., s.111(1) order; (2) per ibid., s.107, an
application to the court may be made for the order; (3) per ibid., s.108 read with
Financial Services and Markets Act 2000 (Control of Business Transfers)
(Requirements on Applicants) Regulations 2001, §3, notices must be
published; (4) per ibid., s.109, a scheme report must be prepared, etc. <a href="#27a">Return to article</a>

<a name="28">28</a> See Companies Act 1985,
s.425(2). Concern, heard expressed by U.S. assureds that a solvent scheme
enables a solvent insurance company to evade paying claims in full, is
allayed by the need for agreement of a majority in number representing at
least three-quarters in value of the company's relevant liabilities. <a href="#28a">Return to article</a>

Journal Authors

Richard Astor

Journal Date

Wednesday, September 1, 2004 - 12:00

Bankruptcy Rule

2004