INSOLVENCY
A commentary article reprinted from the July 15, 1998 issue of Mealey's Litigation Report: Insurance Insolvency
Reinsurance is a global business. It makes sense, therefore, that when a reinsurer fails, there are global repercussions. A recent decision by the Grand Court of the Cayman Islands under-scores the ripple effect of a reinsurance insolvency, as well as the choice of law considerations that come into play when a court must resolve disputes arising from a reinsurer's failure.
In Re Transnational Insurance Company involves an appeal from a partial denial of a claim submitted by an insolvent U.S. reinsurer with the liquidator of an insolvent Cayman Islands reinsurer. The Cayman Islands court ultimately ruled that moneys drawn down on a letter of credit posted as security for judgment in a U.S. suit had to be offset against the insolvent U.S. reinsurer's claim. While the court ruled against the insolvent reinsurer U.S. on the offset issue, the court did allow for IBNR and interest on moneys due.
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In March, Mealey's published a decision by the Grant Court of the Cayman Islands redolent of irony and turnabout as fair play. Transnational slip opinion, Docket No. 61 of 1993 (Grand Court of the Caymans, March 4, 1998); Mealey's Insurance Insolvency, Vol. 9, No. 20 at 8 (March 9, 1998).
You may have skipped over the decision. After all, it involved an insolvent Cayman Islands reinsurer, Transnational Insurance Company, Ltd. ("Transnational"), a defunct Kentucky reinsurer, Delta America Re Insurance Co. ("Delta"), and English and Cayman Islands law.
Transnational, however, merits a closer look for at least three reasons. First, the decision nicely illustrates the interplay between U.S. law requiring that non-authorized reinsurers post "pre-answer security," and English and Cayman Islands law on the winding-up of insolvent insurers and reinsurers. Second, it shows Delta's liquidator submitting a claim--and getting credit on his claim---for both IBNR and interest, even though: (1) ceding companies submitting claims to the Delta estate get interest only from the date their claim is approved for payment; and (2) the current Delta Dividend Plan doesn't allow for IBNR. Third, the decision reveals how courts abroad are responding to judgments obtained when an alien insurer and reinsurer fails to post "pre-answer security" in U.S. court proceedings. First, some background.
Delta Fails
National Distillers (now Quantum Chemical) created Delta, initially known as Elkhorn Insurance as a captive insurer. National Distillers incorporated Elkhorn in Kentucky, where National Distillers was located.
In the early 1980s, Elhorn evolved into Kentucky's only professional reinsurer, and eventually became Delta America Re. Although Delta remained a Kentucky corporation, it operated from a Fifth Avenue office in New York City and was licensed in both Kentucky and New York.
In 1984, Delta entered into a quota share retrocessional contract that transferred to Transnational a percentage of Delta's liabilities on various reinsurance contracts. Months later, in September 1985, the Kentucky Department of Insurance moved to liquidate Delta. For an overview of the liquidation (and the litigation it gave rise to), see Delta Holdings, Inc. v. National Distillers & Chem. Corp., 945 F.2d 1226 (2d Cir. 1991), cert. denied, 152 S.Ct. 1671 (1992).
In 1987, Delta's liquidator commenced several suits against Delta's retrocessionaires. For jurisdictional reasons that need not detain us here, most of these actions were either transferred to or commenced in the southern District of New York. The liquidator's action against Transnational, as well as three other actions brought by the liquidator, were consolidated for discovery purposes and assigned to Magistrate Kathleen Roberts.
Before the retrocessionaires could answer the complaint, Delta moved to compel all alien or non-authorized reinsurers to post security for judgment pursuant to NYIL § 1213©. This statute, which is derived from the Unauthorized Insurers Process Act, requires that before an unauthorized or alien insurer can file any "pleading," for example an answer, the insurer must post security for any potential judgment against it.
Delta's retrocessionaires opposed the motion for pre-answer security on several grounds. They argued, among other things, that the Unauthorized Insurers Process Act was aimed at "fly-by-night," mail order, U.S.-domiciled insurers that used the radio in the 1940s to sell insurance policies. These thinly capitalized companies had been issuing policies from distant locales in the U.S., and then fighting claims (and eventual judgments) on jurisdictional grounds.
The Unauthorized Insurers Process Act was essentially a long-arm statute aimed at those practices. See Attorney General Nathaniel Goldstein's Memorandum for the Governor re: Assembly Int. 1618, Pr. 3317 (April 5, 1949); Insurance-Regulation of Mail Orders, 1970 Session Laws, Ch. 295 at 4091. Delta's retrocessionaires argued that the Unauthorized Insurers Process Act was never intended to apply to a reinsurer's reinsurers.
The retrocessionaires' arguments against pre-answer security failed, not only before Magistrate Roberts, Morgan v. American Risk Management, Inc., 1990 WL 106837 (S.D.N.Y. July 20, 1990), but in many later cases as well. See, e.g. Curiale v. Ardra Ins. Co., 189 A.D.2d 217, 595 N.Y.S.2d 186, 87-88 (1st Dep't 1993). Transnational posted a $735,393 letter of credit and filed its answer. Transnational alleged, among other things, that its retrocessional contract with Delta should be rescinded because Delta had failed to disclose that it was already insolvent when it ceded business to Transnational.
The parties in the consolidated Delta cases began discovery on a variety of issues and defenses. (In fact, the parties deposed more than 150 witnesses, reviewed hundreds of thousands of documents, and took several appeals to the Second Circuit.)
While this discovery was underway, Transnational's obligation to post security for judgment increased because Delta's paid claims increased. Of course, Delta wasn't actually paying any claims. Delta only recorded on its books the amounts being reported as paid by Delta's cedants. Nevertheless, Delta's liquidator insisted that Transnational increase its letter of credit. In addition, Transnational had incurred legal expenses defending against the liquidator's suit.
Transnational Fails
In January 1993, Transnational entered into voluntary liquidation in the Cayman Islands. This would ordinarily have called for a non-supervised winding-up of the company's affairs. Two months later, however, faced with the prospect of continued involvement in the litigation against it in New York, as well as the prospect of litigation commenced by Delta's liquidator in the Cayman Islands, Transnational obtained an order placing its winding-up under court supervision. Slip op. at 2.
After Transnational was liquidated, it couldn't post additional security. Delta's liquidator moved in the Southern District of New York for a default judgment. Because Transnational couldn't provide additional security, Transnational couldn't file any additional "pleadings" in the District court to oppose or stay the liquidator's motion for a default judgment, which the District court ultimately granted.
Armed with the default judgment, Delta drew down on the letter of credit, along with the letter's accrued interest. This brought the total amount collected by Delta's liquidator to $840,000.
Meanwhile, Transnational's winding-up was moving at a brisker pace than Delta's liquidation. The time came for Delta's liquidator to submit Delta's claim to Transnational. Delta's claim totaled $1,583,648.40, but didn't include the $840,000 drawn down on the letter of credit.
Transnational's liquidator was willing to recognize Delta's claim in the amount of $1,260,445.20, but the estate could only pay 34.8% dividend or $541,239. At this point Delta had, as a result of it s drawn down on the letter of credit, already received about $400,000 more than Transnational would have paid Delta pursuant to its proposed 35% dividend. Delta appealed the liquidator's decision to offset the amount drawn down against Delta's claim.
The Parties' Positions
Delta argued that the $840,000 it had already collected was "unconditional security" for its default judgment. The Cayman Islands Court summarized the liquidator's argument this way:
Notwithstanding the blameless default of Transnational in not having the ability to fully contest the New York action, Delta Re was therefore---the argument goes--entitled to recover the amount of its security and remains now entitled to prove for the balance of its claim in the liquidation, without any discount for the sum of the letter of credit.Slip op. At 8.
Transnational argued that the letter of credit didn't create a "security interest" in Delta's favor. Transnational maintained that recovery on the letter of credit was conditioned on Delta's obtaining a judgment against Transnational, but Delta only got its default judgment as a result of Transnational's being liquidated and placed under Grand Court supervision.
Transnational insisted that as soon as Delta's liquidator knew that Transnational was in liquidation, Delta could only draw down on the letter of credit subject to a "statutory trust for the benefit of all Transnational creditors." Transnational argued that the draw down should be considered as an "advance dividend payment" and asked that Delta "be ranked with all other creditors of the estate and its draw down-dividend---discounted so that Delta Re wouldn't be preferred over other non-secured creditors." Slip op. at 9.
In November 1997, the Grand Court conducted a hearing. Along with other evidence and argument, Transnational offered affidavits from William Primps and Ira Reid with the New York firm of LeBoeuf, Lamb, Greene & McCrae, and offered them as witnesses for cross-examination at the hearing. Messrs. Primps and Reid testified on New York law governing letters of credit as well as principles of reinsurance and U.S. bankruptcy law.
Delta offered, among other things, an affidavit from Daniel Hargraves with the New York firm of Costigan, Hargraves and McConnell. Delta also produced Mr. Hargraves for cross-examination. The Grand Court issued its decision in March.
The Grand Court and the Experts
The court first considered whether the letter of credit turned Delta into a "secured" and, hence, preferred Transnational creditor. The court found that under both U.S. and the Cayman Islands law, a letter of credit acts as a "form of security guarantee enforceable according to its terms." Slip op. at 9 citing In Re Compton Corp., 831 F.2d 586 (5th Cir. 1987). Under Compton, the proceeds from a letter of credit belong to its beneficiary, subject to the beneficiary's satisfying the letter's terms.
Mr. Reid testified concerning U.S. Bankruptcy Court practices. He pointed out that had Transnational's liquidators sought to stay the Delta proceedings against the estate pursuant to Bankruptcy Code § 304, a stay would, in all probability, have been granted. The court, however, rejected this testimony as "hypothetical" and "unhelpful" and assumed that the letter of credit constituted a type of secured claim against Transnational.
The court next addressed Transnational's argument that Section 100 of the Companies Act controlled. Section 100 provides that when a winding-up order has been entered against a company, "no suit, action or other proceedings shall be proceeded with---against the company," except with leave of the liquidation court. The court found that Section 100 is merely "statutory reinforcement" of the principle that when an entity is being would up, all of the failed venture's assets are 'impressed with a trust' calling for the equitable and pro rata distribution of the assets to the failed company's creditors." Slip. Op. at 11.
The court, however, rejected the argument that Delta was "automatically enjoined" from drawing down on the letter of credit once Transnational was liquidated. While a Grand Caymans Island court might enjoin a creditor located in the Caymans or subject to the court's personal jurisdiction from proceeding with litigation against Transnational, a Cayman Islands court wouldn't ordinarily try to "restrain a foreign litigant domiciled abroad from suing in the courts of its (own) domicile to recover a secured dept owing to it there." Slip op. at 11-12 citing U.K. authority.
Quoting from an 1879 House of Lords decision, the court noted that a creditor might collect on a secured claim in another jurisdiction, return to England, keep what he secured abroad, and "ignore the English bankruptcy altogether if he pleased."
[I]f [, however, the judgment creditor] did not ignore [the U.K. insolvency proceeding], if he sought to take advantage of it, if he sought to have some benefit from it, then, on the principle that he who would ask for equity must do equity, he must bring into the common fund that which he had already received...Slip op. at 13, quoting Banco de Portugal v. Wadell (1879-80 5 App. Cas. 161.
This rule had been applied more recently in another case cited by the Cayman Islands court in which a U.K. court refused to restrain a debtor subject to the court's jurisdiction from going abroad to pursue a debtor's assets. The U.K. court concluded that the better course would be to allow the debtor to collect the debtor's assets wherever the creditor could locate them outside the U.K. But, if the debtor returned to the U.K. and filed a claim with the estate, the creditor should "give up for the benefit of other creditors any advantage which he may have obtained for himself by the proceedings abroad." Slip op. at 14 quoting In Re Vocation (Foreign) Ltd., (1932) 2 Ch. 196.
The Cayman Islands court held that Delta should be "deemed to have had notice that those sums (covered by the letter of credit) were impressed with the statutory trust which now obliges the liquidators to discount them for the purposes of dividend declaration." Slip op. at 16. If Delta's liquidator continued to press his claim for a dividend payment, he would have to "give up the benefit of the sums recovered by means of the letter of credit for the sake of the liquidation as a whole," which would be but an "arithmetic application of the hotch-pot rule." Slip op. at 17. (The "hotch-pot rule" refers to a "blending or gathering together of properties for the purpose of securing equality of division," particularly as applied to the distribution of the assets of an interstate parent. B. Garner, A DICTIONARY OF MODERN LEGAL USAGE 270 (1987) ed.).)
The court observed that his part of its opinion was consistent with the procedures a U.S. Bankruptcy Court would follow acting pursuant to Section 304 of the U.S. Bankruptcy Code as described by Mr. Reid. To wit, a "New York bankruptcy court would also ordinarily---require their own domiciliary creditors to submit in the liquidation of foreign companies conducted by respected and friendly foreign courts and to rank and account in them with all other creditors." Slip op. at 19 citing In Re Rubin, 160 B.R. 269 (S.D.N.Y. 1993).
IBNR & Interest
Delta's liquidator included within his $1.5 million claim, a claim for $800,744 in IBNR. The Grand Court considered IBNR to be a form of contingent liability which, under Cayman Islands insolvency rules, must be discounted at a rate of 5% per year. In this case, that meant a 5% discount on the reducing balance per year for the 12-year period over which Delta's liquidator projects Delta's IBNR will develop. This discount to present value reduced the IBNR claim to $520,505 for purposes of calculating a dividend.
Transnational advanced two arguments to defeat the IBNR portion of Delta's claim: (1) under the follow the fortunes clause in the reinsurance contract, Transnational only paid claims that Delta paid; and (2) even if the Court didn't rely on the principle of follow the fortunes, the Delta Creditors Dividend Payment Plan made no provision for IBNR.
Delta's Plan calls for dividends to be calculated based on paid losses and case reserves, but without provision for IBNR. Transnational argued that it would be unfair to allow Delta to submit a claim for IBNR when Delta's ceding companies couldn't do the same, and that allowing Delta to add IBNR to is claim under these circumstances would give Delta a "windfall."
Delta responded by arguing that its reinsurance contract with Transnational had to be construed pursuant to New York law. The contract contained a standard insolvency clause which, under New York law, converted the contract from an indemnity to a liability contract once Delta became insolvent. If viewed as a liability contract, IBNR constituted a future liability and should have been part of Delta's claim.
Of course Delta was insolvent. Therefore, according to Delta's liquidator, the insolvency clause took precedent over the follow the fortunes clause. Even though Delta wasn't allowing claims for IBNR now, Delta had not ruled out doing so, nor did the Plan bar payment of some IBNR if these claims were converted to paid claims or case reserves.
The Court agreed with Delta's liquidator. The Court concluded that to ignore the IBNR liability estimates would "refute the actuarial assumptions which are otherwise to be regarded as valid." Disregarding the IBNR projections would also diminish Delta's liability based on its insolvency, which the insolvency clause prevented a reinsurer from doing. The court pointed out that the Delta Dividend Distribution Plan did allow for possible future dividends to meet the IBNR claims, "which may crystallize in the course of its winding up and so may become actual paid losses." Slip op. at 27.
Finally, the Court granted Delta's claim for interest. Initially, the court understood that Delta's claim related to interest on the security for judgment letter of credit. Since the court held that this money had to be credited to the estate, any interest awarded would have benefited Transnational, not Delta. During the hearing, Delta clarified its position as seeking interest on claims due on the reinsurance contract, which required payment of all claims within sixty days of presentment.
Applicable Cayman Islands insolvency rules allow for interest if there exists a written instrument that requires payment "at a certain date." The quota-share reinsurance contract didn't expressly refer to interest, but the court relied on a requirement in the contract that all claims be paid within sixty days of presentment. The court allowed interest on amounts that Transnational owed the estate calculated from sixty days after presentment until January 15, 1993, the date Transnational was placed in liquidation.
Observations
It's difficult to quarrel with the court's decision to offset moneys drawn down on the letter of credit against Delta's claim against the Transnational estate. Allowing Delta to collect its full share of Transnational's initial dividend without recognizing the moneys drawn down on the letter of credit would have given Delta a preference over other Transnational creditors. In fact, Delta having helped push Transnational into insolvency in the first place, would wind up recovering considerably more than other, similarly-situated creditors.
It's peculiar that Transnational never sought the protection afforded by Section 304 of the U.S. Bankruptcy Code. Other insolvent Cayman Islands insurers have used Section 304 to stay U.S. proceedings. Indeed, one of the leading Section 304 cases involved a failed Cayman Islands surety insurer. See In Re Gee, 53 B.R. 891 (Bankr. S.D.N.Y. 1985). There's little doubt, as Mr. Reid explained during his testimony, that had Transnational obtained a Section 304 stay, Delta's liquidator wouldn't have been able to obtain a default judgment. Without the default judgement Delta Re couldn't have drawn down on the letter of credit.
At first glance it may look strange that Delta elected to press its claim in the Cayman Islands. After all, the amount drawn down on the letter of credit was considerably larger that Delta's total claim discounted by the 35% dividend that Transnational will pay out. But Delta's liquidator has a fiduciary duty to press for every dollar in assets that the estate can recover. At the time the decision was made to submit a claim to the Transnational estate---and thus submit Delta to the jurisdiction of the Cayman Islands court---there was a possibility that additional moneys could be collected.
The Grand Court gently pointed out that Delta's liquidator was well aware of Transnational's insolvency before he pressed forward with his application for a default judgment, and then drew down on the letter of credit. Slip op. at 10-11. In fact, the Cayman Islands winding up procedure stayed all proceedings against Transnational "except with the leave of the court," which Delta never sought.
The Cayman Islands court, however, didn't take umbrage. The court instead looked to U.K. cases that allow a creditor to pursue a debtor's assets in other jurisdictions.
In another recent decision, however, a U.S. liquidator's failure to honor a stay of proceedings was a ground for refusing to enforce in Bermuda a U.S. judgment. That case also involved a default judgment based on a failure to post pre-judgment security. Muhl (as liquidator of Nassau Insurance Co.) v. Ardra Insurance Co., Ltd. 1 Offshore Financial Law Reports, at 98 [1997-98].
In Muhl, the Liquidator of an insolvent New York Company used NYIL 1213(c) to obtain a default judgment against an insolvent Bermudan reinsurer. The liquidator then sought to execute on the judgment in Bermuda. The Bermudan Supreme Court refused to enforce the judgment on two grounds.
First, the court in Muhl held that the U.S. liquidator had pressed forward with its suit against the Bermudan reinsurer, including the institution of civil and criminal contempt proceedings against its former officers, in violation of a Bermuda order staying the U.S. proceedings. Second, the Court held that the %15,000,000+ default judgment against the Bermudan reinsurer had been obtained against a company that could only post 1/10th that amount in security. The judgment itself, therefore, was "contrary to substantial or Natural Justice" and would not be enforced under U.K. law. 1 O.F.L.R. at 214.
In Transnational, Delta didn't try to enforce a judgment because, unlike the Bermudan reinsurer in Muhl, Transnational was insolvent. Had Transnational been solvent but unable to post the pre-answer security demanded, Transnational would presumably have had the same "substantial or Natural Justice" defenses to enforcement of the judgment in the Caymans.
The Court's holdings in Transnational with respect to IBNR and interest are harder to follow. It's true that the Delta Dividend Plan didn't rule out the possibility that Delta will make a dividend distribution based on IBNR. See " Delta America Re's Dividend Plan. Why (Almost) No One Objected." Mealey's Insolvency Reports, Vol. 8, No. 12 at 405. At this point, however, the Delta's IBNR figures are based on an actuarial report that may or may not accurately reflect true claims exposure.
Perhaps the Transnational Court should have deferred a ruling on this issue until it could be determined whether there will be any IBNR paid out of the Delta estate. If not, it would appear that allowing Delta to collect IBNR from the Transnational estate, when it isn't paying any dividend IBNR in the Delta Insolvency, is a windfall, but one that will eventually inure to the benefit of Delta's creditors.
With respect to interest, the Delta Dividend Plan provides that the estate will pay no interest until sixty days after the Delta liquidation court approves a claim for payment. This means that if Delta pays the approved claims within the allotted time, Delta's cedants won't receive any interest on claims honored a full thirteen years after the company was liquidated. The Caymans court, however, allowed Delta a credit on its claims running from sixty days after presentment at an eye-popping rate of 15% per annum.
Delta's letter of credit draw down still exceeds the amount of Transnational's 35% dividend, even adjusted for IBNR and interest. Delta's liquidator, however, has appealed the Grand Court's order. And Transnational has cross-appealed from the order, insofar as it allowed IBNR and interest. A three-judge panel will hear the appeal in March 1998.