Editor's Note: Bankruptcy practitioners in Europe are often in the fortunate position of being able to assist U.S. lawyers involved in developing a chapter 11 plan by making use of similar methods of compromising claims on the other side of the Atlantic. Very often, this assistance occurs within the framework of two sets of parallel proceedings with the shared objective of a deal that will bind all relevant creditors (whether subject to U.S. jurisdiction or not). Our article this month considers "schemes of arrangement," which for more than 100 years have played the role of a chapter 11 plan in the United Kingdom and throughout the Commonwealth.

A scheme of arrangement under §425 of the Companies Act of 1985 is a procedure under which a company may make a compromise with its creditors or any class of them. Schemes have been used in the United Kingdom (and in many other Commonwealth jurisdictions) for many years. It is the nearest U.K. equivalent to a chapter 11 plan.

In this article, we consider how the courts have approached challenging issues that have recently arisen in two contexts where schemes are used: first, where they are used as part of a financial restructuring to compromise bondholders; and second, where they are used to shorten the run-off of solvent insurance companies.

A three-stage process exists for promoting a scheme of arrangement:

• A company must apply to the court for permission to hold a meeting of its creditors. This can be one meeting unless it is felt that different classes of creditors have rights that are so different that they cannot reasonably consult together with a view to a common interest (the so-called "common-interest test"). In that case, a separate meeting is held for each class.
• Meetings are then held, and each class must vote in favour of the scheme by a simple majority in number and 75 percent in value.
• The company then returns to court for sanction of the scheme. The court must exercise its discretion and be satisfied that the scheme is fair and such as an intelligent and honest creditor voting in his own interest might reasonably approve.

It is the responsibility of the applicant to determine the correct classes. If the classes are incorrectly constituted, the court will not have the jurisdiction to sanction the scheme at the third stage. The common-interest test is a high hurdle, and many schemes proceed on the basis of a single class. Because any class can block the scheme, the concept is very different from class voting in a chapter 11 reorganisation plan.

When sanctioned by the requisite majority and the court, a scheme will bind all members and creditors, regardless of whether they had notice.

Bondholders and Schemes

The role of bondholders within U.K. restructurings has increased dramatically over the past few years. This is because of the increasing complexity in capital structures and the growth of U.S.-based investors in European debt.

When a company is in financial difficulties, the ideal solution is a consensual restructuring, but due to the varied interests of the stakeholders, most "consensual" workouts will inevitably involve some sort of cramdown or threat of cramdown. The starting point is that all unsecured financial creditors should be treated equally, but there will inevitably be those who try to extract more value by holding out for a better deal.

Schemes can provide for such a cramdown mechanism, as there is no requirement for unanimity. Recent examples of bondholder restructurings where a scheme has either been used or threatened include Marconi, Drax, Telewest, British Energy and MyTravel.

Why Are Bondholders Different from Other Creditors?

The way in which bonds are typically held and the type of investors who deal in bonds differentiate bondholders from other creditors. This will have an impact on the way in which negotiations are conducted with bondholders prior to launching the scheme and potentially also the way in which bondholders are treated under the scheme itself.

Typically, bonds are widely held by a varied group of investors who have different objectives in the restructuring (for example, distressed-debt traders or bondholders who bought at par). The bondholders may also have a weaker position than some other stakeholder groups as their claims are likely to be unsecured and will often be structurally subordinated. Bondholders' positions in the negotiations may also be further affected as, unlike banks, the bond-holders will have no ability to underwrite new cash.

Another important difference is that where a company is dealing with bondholders, it cannot be certain of who its creditors are or who they will be at each stage of the restructuring. This is because bonds are often held in global form and can usually be freely and publicly traded. Consequently, the company will be negotiating with a changing creditor constituency during the course of the restructuring.

Are Bondholders Treated Differently in a Scheme of Arrangement?

Bondholder schemes are likely to be an alternative to insolvency, so the starting point for determining whether or not they are in the same class as other bondholders or other groups of creditors will be their rights in a hypothetical liquidation.

Viewed in this way, all bondholders are capable of being in the same class, even where they hold different issues of bonds, with different maturity dates or interest rates, or in different currencies. However, although in theory bondholders may be likely to form just one class together with other creditors, in practice some bondholders can be aggressive litigants who play the class game in an attempt to extract value. In addition, different bondholders may have collateral rights that could potentially place them in a separate class.

The way in which agreements are reached with bondholders prior to launching the scheme could also have an impact on whether or not bondholders form part of the same class. Given the time and expense involved in launching the scheme, once scheme proposals have been agreed upon, it is in the interests of both the company and the creditors that a significant number of creditors enter into voting agreements to support the scheme. This will also help the company put in place other elements of the restructuring during the court process by giving it increased certainty that the scheme will be successful. The court has recently confirmed that voting agreements entered into by scheme creditors before the launch of a scheme do not necessarily cause class issues if the scheme creditor would not have voted differently in the absence of the agreement.²

A similar issue could potentially also arise in relation to payment of the fees incurred by some, but not all, creditors. It is common practice for the legal fees and expenses of the bondholder committee to be paid by the company being restructured. The courts have confirmed that the payment of legal fees incurred by the bondholder committee or other creditors involved in the restructuring process does not, of itself, cause any class issues so long as the payment was not made to "buy" the vote.

Are Bondholders "Creditors" in a Scheme?

In a chapter 11 plan, bondholders are counted as creditors in their own right and are entitled to vote on the plan of reorganisation, even where the bonds are held in global form and the depositary or trustee has legal title. However, the position in England is more complicated. A "creditor" for the purposes of a scheme of arrangement is any person who has a pecuniary claim against the company, whether present or contingent.³

Where the bonds are held in global form, the depositary and/or the trustee are likely to be the "creditors," depending on the working of the indenture or trust deed. Legally, the underlying bondholders who have the economic interest in the bonds are not actually creditors. In practice, the depositary/trustee would only exercise its vote in accordance with the wishes of the bondholders.

This causes a further difficulty where bondholders make up the vast majority of the stakeholders being compromised under a scheme. The statutory voting test for a scheme is that a majority in number representing three-fourths in value of the creditors or a class of creditors present and voting must vote in favour. While the bonds remain in global form, this will result in the views of the underlying bondholders counting toward the "at least three-fourths in value" limb of the statutory test (as the trustee will exercise its votes in accordance with their wishes), but not the "majority in number" limb.

The voting mechanics of a scheme will need to address this issue. How it is addressed will depend on the terms of the bonds, but it can often be time-consuming and expensive. For example, one approach that has been used is to require bondholders who wish to vote to convert their bonds into definitive form. This will then give the bondholder a direct claim against the company.

While the English courts have in practice insisted upon definitisation of bonds for voting purposes, we are aware of schemes in other jurisdictions where the courts have been prepared to look through the strict legal position and allow bondholders to vote for their beneficial holdings.

Conclusion

Although schemes have been used historically where bondholders or other large creditor groups are being compromised in a restructuring, there is an alternative means of cramming them down under English law. This is a company voluntary arrangement (CVA), a procedure under the English insolvency legislation (though there is no requirement of insolvency) having similar effect to a scheme.

Following changes in the law relating to CVAs, which came into force in 2003, it is now possible to bind creditors that do not have actual notice of the CVA proposals in the same way as a scheme. This means that there is now the potential to use CVAs in more complicated compromises. This was done last year when the U.K. companies that made up the TXU Group successfully implemented two separate sets of interlocking CVAs. As there is no requirement for classes of creditors to vote separately in a CVA, it seems likely that CVAs may prove more popular than schemes in the future.

Insurance Schemes

Insurance schemes are now a common feature of the London insurance market. They allow insurance companies with large numbers of expired policies to cut off liabilities now, rather than wait decades for claims to emerge and be paid in the ordinary course. In the typical solvent scheme, creditors (i.e., policyholders) are given a deadline (called the bar date) by which they must submit to the company all claims they may have. This includes contingent claims, which are estimated according to an actuarial methodology. There will then be a process whereby the value of claims is agreed to or adjudicated by an independent expert, and the company then pays everyone in full and is left with no liability.

BAIC

On 21 July 2005, the solvent scheme of arrangement proposed by British Aviation Insurance Co. Limited (BAIC) became the first to be successfully challenged at a sanction hearing.⁴ The insurance liabilities that BAIC was seeking to accelerate included long-tail asbestos and pollution liabilities under loss-occurrence policies, as well as reinsurance liabilities.

The primary challenge was that the court had no jurisdiction to sanction the scheme as only one meeting of creditors had been held, whereas creditors with accrued claims (who would be paid in full) and creditors with contingent claims (who would have their claims estimated) should have formed separate classes.

The judge decided that the question of whether creditors' rights were similar was to be answered by reference to a reasonable comparator – i.e., what would creditors' rights be outside the proposed scheme as compared to their rights under the scheme?

The company argued that if the company were to be wound up, contingent creditors would have their claims estimated and therefore all creditors would be treated similarly under the scheme. However, the judge found that winding up (whether solvent or insolvent) was not a realistic alternative to a scheme for BAIC. He said that the risk of BAIC going into wind-up mode was remote and theoretical, as it had a very healthy balance sheet and shareholders who would support it for reputational reasons. Therefore, the only realistic comparator was a solvent run-off. Applying that comparator, the judge found that the two types of creditors had interests that were sufficiently different in that they had no common interest at all and should form separate classes. He therefore had no jurisdiction to sanction the scheme.

The judge went further and commented, obiter, that if he had had jurisdiction, he would still not have sanctioned the scheme as the company was able to meet its liabilities, and it was unfair for those insureds with contingent claims to have their insured risk compulsorily retransferred to them. BAIC was in the risk business; direct policyholders were not.

Subsequent Developments

There was some concern in the run-off industry over what impact the BAIC decision would have upon future solvent schemes. New schemes were initially put on hold pending an appeal, but the decision is now not to be appealed.

The next solvent scheme hearing came in September 2005, when the Court of Session in Scotland (where the law on schemes is largely the same as in England) sanctioned a solvent scheme for M&G. Lord Clarke was referred specifically to BAIC but declined to follow it, both as to class constitution and as to fairness.

The most significant development following BAIC has come in the joint cases of Scottish Eagle Insurance Company Limited and La Mutuelle Du Mans Assurances IARD (MMA). In both cases, a single meeting of creditors was held, but Mr. Justice Evans-Lombe sanctioned both schemes on 28 Oct., albeit on different bases. In the case of Scottish Eagle, he held that the BAIC analysis allowed a single meeting to be held because it was demonstrable that it would be a realistic alternative for Scottish Eagle to be placed into solvent liquidation. For MMA, he held that this could not be said, but that there must be cases, MMA plainly being one, where the nature of the claims was very different from the insurance business that the BAIC judge examined. He held that the court must be able to say that the claims are so similar that, although there could not reasonably be a prospect of a solvent liquidation, nonetheless accrued and contingent claims were so similar, in the nature of the calculation required to arrive at quantification, that creditors were able to consult together with a view to their common interest. Perhaps significantly, the major difference from BAIC was that no creditors opposed sanction of the MMA scheme.

Future Developments

Insurance companies thinking of proposing schemes can rest easy that the courts have not rigidly applied the decision in BAIC. However, the schemes that have subsequently succeeded have done so on the basis of distinguishing BAIC rather than challenging it. A scheme on similar facts to BAIC will be the next big test for this increasingly popular exit option.

 

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Footnotes

1 Contributing authors were Neil Golding, Catherine Derrick and Craig Montgomery in London.

2 Re Telewest Communications Plc (No.1) [2004] B.C.C. 342.

3 Midland Coal, Coke and Iron Co. [1895] 1 Ch 267

4 Re British Aviation Insurance Co. Ltd. [2005] EWHC 1621 (Ch).