Captive manager Arsenal files for bankruptcy amid allegations of fraud

Picture the beautiful mansion of your dreams. The mansion is available at what seems like a very low price, and you jump to buy it. Before you even get fully moved in, however, a heavy rain comes which soaks the ground and your mansion starts to fall into a giant sinkhole. Turns out that the beautiful mansion was built on a limestone formation, and it was inevitable that the sinkhole would develop.

Thus does your dream mansion turn into a big pile of useless rubble at the bottom of the sinkhole, and much more quickly than you thought was even possible. And that brings us to the bankruptcy of captive insurance manager Arsenal.

On January 26, 2023, Arsenal Insurance Management filed for Chapter 11 bankruptcy in the US Bankruptcy Court for the District of Delaware. You can read the petition here. On the same day, a Chapter 11 petition was filed for related companies Arsenal Health, which you can read here, and for Arsenal Intermediate Holdings, which you can read here. The creditor matrix for all three companies is found here.

To fully understand why Arsenal failed, you have to go back to its inception—the building of the beautiful mansion. This story is chronicled in a Memorandum Opinion issued by the US District Court for the Middle District of Alabama in the case of Jarvis v TaylorChandler, Case No. 17-CV-396 (M.D.Ala., Aug. 19, 2020). The court begins its opinion by stating that “this case is a contract dispute between sophisticated businessmen. It has Internal Revenue Service (IRS) bulletins, complicated life insurance plans, and more accountants than a golf course on April 16th.” The court notes that it held a multi-day bench trial (that is, without a jury) and took the testimony of the key players and various experts. You can read that Memorandum Opinion  here, and it is quite the entertaining read.

Sparing you, dear readers, a lengthy synopsis of the 76-page Memorandum Opinion, let me just give you the highlights. Christopher Jarvis, whom the court describes as: “the proverbial man with the plan; the sort of financial fixer that one sees in movies and television shows”, formed a captive manager called Jade Risk in 2011 to sell captive insurance tax shelters sometimes featuring cash value life insurance arrangements to small business and, seemingly, mostly physician practices. By 2015, Jarvis wanted out of the captive business, and sold Jade Risk for $3 million ($2.25 million up-front with $750,000 deferred) to an accounting firm in Montgomery, Alabama, called TaylorChandler, which was owned by Britt Taylor, Norman Chandler, and Johnny Johnston.

TaylorChandler itself owned the aforementioned Arsenal Insurance Management, and Johnston had 25 years of experience with the Alabama Department of Insurance. Apparently, Jade Risk was then merged into Arsenal Insurance, with Jarvis becoming an employee of TaylorChandler until his buyout was completed. This was TaylorChandler buying the beautiful mansion that I mentioned at the start of this article, with Jade Risk bolstering Arsenal Insurance’s captive business for what then probably seemed like a low price (considering that other captive management firms sold around the same time for much more, albeit they had a lot more captives under management). But then it began to rain, and the sinkhole soon developed.

There seem to be two major problems: First, the wheeler-dealer approach of Jarvis to selling aggressive tax strategies in the form of microcaptives is said to have rubbed the conservative Chandler the wrong way, and he and Jarvis apparently frequently clashed. Second, before the paint on the merger had even fully dried, the sky fell on the microcaptive tax shelter sector. Recall that the merger occurred in 2015. By this time, there were a lot of rumours floating about that the IRS was going to get serious about taking on so-called “microcaptives”, being risk-pooled captive insurance companies that had made the IRC §831(b) election, aka “831(b) captives”. Indeed, it was these rumours which prompted some other owners of captive management firms to similarly sell out while the getting was good. We know now, with the clarity of hindsight, that the IRS had in fact by 2015 notified certain captive managers that they were the subject of a promoter examination, but such was all just vague rumours at this point.

Then, the following year, in 2016, the IRS issued Notice 2016-66 which indicated that microcaptives were a “transaction of interest” (even today, nobody is exactly sure what that means, but it sounds pretty bad), and although that Notice was vacated six years later in 2022, the effect in 2016 was to chill new sales of microcaptive arrangements for all but the most foolhardy and utterly naïve of taxpayers (read: a few doctors). The smarter taxpayers with microcaptives consulted with their tax advisers, and then started the process of winding them up.

Prospective clients whom Jarvis had been talking with about forming a captive were no longer taking his calls. Some of the captives that were in the progress of formation were halted. Other, existing captive owners decided to wind their captives up. TaylorChandler’s purchase of Jade Risk had been premised on the expectation that Jade Risk would be managing at least 36 captives by 2017, but that number was never reached.

Long story short: TaylorChandler and Jarvis soon split the sheets. Jarvis sued TaylorChandler for his unpaid compensation, and eventually on August 19, 2020, the aforementioned US District Court awarded Jarvis about $850,000 or so, plus his attorney’s fees and expenses. Thus did TaylorChandler’s dream mansion crumble into the sinkhole.

The next stage
That only starts the story of how and why Arsenal Insurance and its two affiliated companies filed for bankruptcy. To reach the end, we must now consult the Declaration of Michael Wyse dated January 26, 2023, which you can read  here. It is also very interesting reading, and the following is derived from his Declaration.

Wyse is a professional liquidator of troubled businesses. He was hired to be the liquidator of the Arsenal companies, holding the title of chief restructuring officer. The Arsenal companies have a lot of things going on, but are essentially they are not profitable, and thus need to be closed down. Because the Arsenal companies still have business relationships, counterparties with important interests, and trade creditors, etc, the use of a Chapter 11 bankruptcy proceeding represents a solid and recognised method for shutting these companies down. So what happened?

According to Wyse, the Arsenal companies were managing not just captive insurance companies, but also related arrangements such as self-funded healthcare benefit plans. The risk pool for all these arrangements was an insurance company, run by Arsenal Insurance, called Iron Reinsurance Company (Iron Re), which provided a stop-loss policy to the benefit plans.

All of this apparently seemed attractive to a Delaware organisation called Beyond Risk, Topco Holdings, which used its subsidiary BR Intermediate Holdings to purchase Arsenal Insurance and Arsenal Health on December 2, 2021—about a year-and-a-half after Jarvis won his judgment against TaylorChandler.

This was very much Beyond Risk purchasing TaylorChandler’s beautiful mansion which had collapsed into the bottom of the sinkhole, although Beyond Risk now claims that the sellers talked only about the beautiful mansion when they sold it, and not so much about the sinkhole or the rubble.

A little more than a year after their purchase of Arsenal, on January 26, 2023, Beyond Risk and BR Intermediate Holdings sued Chandler, Justin Law and two apparently affiliated companies (Lansera and Atlantis Group, although their roles are not clear) in the Delaware Chancery Court. The lawsuit alleged that the defendants had engaged in, or aided and abetted, fraud in the sale of Arsenal.

According to Wyse: “In the Delaware Action, the plaintiffs allege that, shortly following their acquisition of Arsenal, two of Arsenal Health’s top six clients informed Arsenal that they would not be renewing their contracts. Upon a review of the client contracts and the health plans, the plaintiffs determined that the two plans had incurred significant deficits, totalling several millions dollars in the aggregate, in sharp contrast to the due diligence provided by the sellers, Chandler and Lansera, in the sale process.”

Wyse goes on to say that Beyond Risk also claims to have found “pervasive” underpricing of policies by Arsenal, and this was concealed by Chandler and Law. Moreover, Beyond Risk alleged that Arsenal’s customers were misled into believing that their healthcare expenditures were capped by outside insurance, when in fact they were basically just self-insuring themselves. Beyond Risk further alleged that Iron Re was improperly used to make up for shortfalls, thus ultimately causing it to be significantly underfunded as well. When Iron Re failed to make payments, Beyond Risk alleges, Arsenal was forced to terminate their agreement.

Chandler and Law were terminated from Arsenal on October 18, 2022, according to Wyse. Shortly thereafter, and as Arsenal’s financial condition continued to worsen, the decision was finally made to send Arsenal off to that corporate slaughterhouse known as bankruptcy, and Wyse was hired to carve up the remaining carcass for the benefit of creditors through the Chapter 11 proceeding. To fund the bankruptcy, BR Intermediate Holdings offered to provide $2.25 million in financing (known as debtor-in-possession [DIP] financing), for Arsenal to continue to operate—albeit under bankruptcy supervision—until the bankruptcy plan has ended.

And now you know the ‘why’ of the bankruptcy of the Arsenal companies. Whether Arsenal will ever emerge from bankruptcy is somewhat of an open question (I can’t image why anybody would want it to, considering its background), and the litigation between Beyond Risk and the Chandler defendants will probably provide interesting reading in the future, though reminding readers that allegations are nothing more than that, and the defendants will have their own facts to present and allegations to prove up.

Analysis
One of the striking things about the Arsenal companies’ bankruptcy petitions is that the IRS is not listed as a creditor. When the background of Jade Risk is considered, it seems likely that at least some (if not all) of its captives were sold and managed as microcaptive tax shelters. If so, then Jade Risk had potential exposure to both IRS promoter penalties and to negligence claims by the captive owners.

Presumably then, such exposure would similarly carry over to Arsenal Insurance as Jade Risk’s successor. This would at least be the case for any microcaptives that Arsenal Insurance managed after the merger with Jade Risk. Thus, a casual observer might wonder whether the Beyond Risk folks—being, apparently, true risk professionals and nothing like tax shelter promoters—realise that what they purchased was not just a pile of alternative risk rubble at the bottom of the sinkhole, but that the rubble might be liability radioactive as well. Seems that, considering the history of Arsenal Insurance, perhaps listing the IRS as a potential creditor and putting them on notice would not have been the worst idea in the world.

Otherwise, what we see with Arsenal Insurance will likely be a common ending for many of the microcaptive managers in a few years.

Many of the microcaptives have either been wound down, or are waiting resolution with the IRS to wind down, and a point will come with each microcaptive manager where they simply don’t have enough captives still paying fees to make the enterprise worthwhile.

This is probably at a point below 20 microcaptives, and of course once the number of clients falls below 12 or so clients, then their risk pool arrangement will not have sufficient risk distribution to even make a straight-faced argument to the US Tax Court to that effect.

In general, the better tax shelters work for a while because they successfully fly under the radar. The promoter sells the transactions to a few clients for a high fee, and then gets out while the getting is good. When a tax shelter becomes popular, as microcaptive transactions (and many other tax shelters of the past) did, then it is dead and those who keep selling—or, worse, jump into the business late—eventually get sliced and diced. Microcaptives are a good example: A number of captive managers who built their books of business on microcaptives but then sold their practices before the storm hit walked away with some good money, including Jarvis here, while the buyers then came into the picture just in time for the inevitable shellacking.

The first microcaptive manager to go down was Clark & Gentry in 2017 which  ceased its business captive business after the US Tax Court’s Avrahami decision. I presume that the next captive manager to file for bankruptcy will be Capstone, which is facing a  $90 million class action judgment that it is unlikely to be able to repay. Following soon enough will be those other captive managers who are under promoter examinations as the IRS finally drops the big hammer on them.

Jay Adkisson is, inter alia, a partner of the law firm of Adkisson Pitet LLP, was the first Chair of the American Bar Association's Committee on Captive Insurance, and has twice been an expert witness to the U.S. Senate Finance Committee. He can be contacted at jay@jayad.com