March 17, 2010
Written by The National Insurance Coverage Group of NLdH
This article is an interpretation of current law and is offered for informational purposes only. This material is not legal advice and should not be construed or used as a substitute for the advice of an attorney.
The current global economic crisis has had an unprecedented negative impact on American businesses, with the predictable result being a dramatic surge in the number of personal and business bankruptcies filed in the United States in 2008 and 2009. According to an August 4, 2009 report by the American Bankruptcy Institute, consumer bankruptcy filings for the month of July alone reached 126,434, representing a 34.3% increase nationwide compared to the same period a year ago. As the economy has faltered, businesses have not fared much better. In the first five months of 2009, 36,106 commercial bankruptcies have been filed across the country, representing a staggering 240% increase over the number of commercial bankruptcies filed during that same period just three years ago.
An insurance policy may be an insolvent insured's most valuable asset. In recent years, the potential availability of insurance assets to satisfy claims against a debtor-insured has increasingly become a focal point of many bankruptcy proceedings. Accordingly, given the importance of the insured's insurance policies, in combination with the tidal wave of consumer and commercial bankruptcies triggered by the current financial crisis, claims professionals are more likely than ever to find themselves litigating an insurance coverage dispute in the unfamiliar world of bankruptcy court.
To the uninitiated, bankruptcy court can be a foreign and confusing forum not only for the claims professional, but also for coverage counsel. Indeed, when it comes to litigating complex insurance coverage matters in bankruptcy court, even the most experienced insurance coverage litigator can feel like the proverbial "fish out of water." On the other hand, a skillful practitioner who understands the complexities and nuances of the bankruptcy system can use that knowledge and experience to the strategic advantage of an insurer who, by chance or by choice, is litigating insurance issues in bankruptcy court.
Increasingly, insurers find themselves litigating important coverage issues in the unfamiliar world of bankruptcy court, and while many perceive bankruptcy court as a potentially unfriendly forum for litigating coverage issues based upon the assumption that the court will naturally be inclined to maximize the debtor's estate, this is not necessarily true. As long as the insurer is represented by coverage counsel well-versed in its procedural and substantive workings, bankruptcy court can actually be a preferred forum for litigating coverage issues for several reasons.
First, compared to their state court counterparts, bankruptcy courts are generally recognized for their superior expertise in dealing with commercial matters including complex contract interpretation. Second, in bankruptcy court, the appellate options are typically broader and the insurer may usually count on two appeals: a de novo appeal from the bankruptcy court to the district court and an appeal from the district court, by right, to the court of appeals. Third, the opportunity to litigate a coverage action in bankruptcy court may give the insurer access to the federal courts in a case where that option might otherwise be unavailable in the absence of diversity jurisdiction.
Bankruptcy: Definition and Purpose
Bankruptcy is the legal process by which the claims of creditors against either an individual or a commercial entity are discharged thereby relieving the person or business of debt that has become unmanageable and unlikely to be repaid. Title 11 of the United States Code sets forth the federal law governing bankruptcy matters. The primary purpose of a bankruptcy proceeding is to give an individual or corporate debtor a fresh start by gathering the debtor's assets, determining which, if any, of the assets are exempt from the claims of creditors, and paying the creditors' claims to the extent possible. While there are various forms of bankruptcy depending on the debtor's status, a claims professional dealing with commercial insureds can generally expect to encounter Chapter 7 and Chapter 11 bankruptcies.
Chapter 7 vs. Chapter 11: What's the Difference?
In a Chapter 7 bankruptcy, referred to as "liquidation," a financially distressed company that cannot be revived is dissolved. In such a case, a trustee is appointed to collect, liquidate (i.e., sell), and distribute nonexempt property of the debtor. See 11 U.S.C. § 701-703. Once all the company's legitimate debts are calculated, the assets are used to pay creditors who typically receive some significantly reduced portion of the actual amount owed by the debtor.
The goal of a "reorganization" under Chapter 11, on other hand, is very different. Chapter 11 facilitates a debtor's management and negotiation of its obligations so that it is able to emerge from bankruptcy as a viable company. Unlike a liquidation under Chapter 7, where the insurer is dealing with an appointed trustee with an ultimate goal of complete dissolution of the entity, in a Chapter 11 reorganization the debtor usually acts as its own trustee - referred to as the "debtor-in-possession," and the goal is to continue the business. . See 11 U.S.C. § 1107. A debtor-in-possession must file a plan of reorganization within 120 days from the filing of the Petition, setting forth the details of the debtor's proposed reorganization which must be voted on by the creditors and approved by the Bankruptcy Court.
Effect of the Insured's Bankruptcy on an Insurer's Policy Obligations
From the perspective of the claims professional, an insured's bankruptcy triggers a host of issues relating to the insurer's obligations under the policy. Liability policies typically include a "bankruptcy clause" providing that the "bankruptcy of the insured or of the insured's estate will not relieve the company of its obligations under the policy" or words to that effect. Such clauses are compulsory in many states. See, e.g., Lang v. Hanover, 3 N.Y.3d 350, 355-56 (2004)("[New York Insurance Law § 3420] makes clear that bankruptcy does not relieve the insurance company of its [policy] obligations").
Jurisdictional Issues
The federal district courts enjoy "original but not exclusive jurisdiction of all civil proceedings arising under title 11, or arising in or related to cases under title 11." 28 U.S.C. § 1334(b). In general, whether a civil proceeding is "related to" a bankruptcy matter for purposes of the district court's jurisdiction pursuant to 28 U.S.C. 1334(b) has been construed very broadly. According to the leading case on this issue, "a civil proceeding is related to bankruptcy...[if] the outcome of that proceeding could conceivably have any effect on the estate being administered in bankruptcy. " Pacor Inc. v. Higgins, 743 F.2d 984, 994 (3d Cir. 1984), overruled on other grounds by, Things Remembered, Inc. v. Petrarca, 516 U.S. 124 (1995).
Although the courts apply a liberal standard in determining whether a proceeding is "related to" a bankruptcy matter for jurisdictional purposes, the bankruptcy court's jurisdiction is not without limits - a bankruptcy court may only preside over issues that offal within its "core" jurisdiction or which involve "non-core" issues that are related to the bankruptcy case.
Core v. Non-Core Proceedings
The distinction between "core" and "non-core" issues was articulated by the United States Supreme Court in Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982) and codified by the provisions of 28 U.S.C. § 157(b) and (c). Significantly, in a core proceeding the bankruptcy court is authorized to "hear and determine" the matter, i.e., the court has the power to render a final judgment. See 28 U.S.C. § 157(b)(1). In contrast, in non-core or "related to" proceedings, the bankruptcy court may only make recommendations, together with findings of fact and conclusions of law, which are subject to review and approval by the district court. See 28 U.S.C. § 157(c)(1). However, an exception to this rule exists where the parties have consented to have their non-core proceeding heard and decided by the bankruptcy court judge. See 28 U.S.C. § 157(c)(2).
A statutory, non-exhaustive list of the types of proceedings that are deemed "core" are enumerated in 28 U.S.C. § 157(b)(2). In general, a proceeding will be considered "core" if it invokes a substantive right under Title 11 of the federal bankruptcy laws or if the proceeding, by its very nature, could only arise in a bankruptcy case. A good rule of thumb for drawing the line between core and non-core proceedings is that non-core proceedings would exist regardless of the bankruptcy whereas core proceedings exist only because of the bankruptcy.
A majority of courts have held that insurance coverage actions, particularly those arising prior to the bankruptcy filing, are "non-core" proceedings. See, e.g., In re Delta Financial Corp., 398 B.R. 382, 406 (Bankr. D. Del. 2008); In re U.S. Brass Corp., 110 F.3d 1261 (7th Cir. 1997) (coverage suit is a non-core proceeding, notwithstanding the importance of insurance as an asset of the bankruptcy estate.) However, some bankruptcy courts have held that a coverage action is a "core" proceeding where the debtor's insurance policies are the debtor's most important asset and the outcome of the coverage dispute will have a significant impact on the debtor's ability to reorganize. See, e.g., In re Celetox Corp., 152 B.R. 667 (Bankr. M.D. Fla. 1993).
Property of the Bankrupt Estate: Treatment of the Policy vs. the Policy Proceeds
Upon the filing of a bankruptcy petition, all property of the debtor, including any rights or interests arising under contracts, becomes the property of the bankruptcy estate. Under the Code, the bankruptcy estate "is comprised of ... all legal or equitable interests of the debtor in property as of the commencement of the case" including "proceeds of or from property of the state." 11 U.S.C. § 541 (a)(1), (a)(6). Courts have interpreted this language to include insurance policies issued to the debtor. See In re Federal-Mogul Global, Inc., 385 B.R. 560 (D. Del. 2008).
Notably, while a debtor's policy is always the property of the bankruptcy estate, an important distinction has been drawn as to the proceeds of an insurance policy, which are sometimes deemed the property of the bankruptcy estate. This issue generally turns on the type of coverage afforded under the policy and, more importantly, whether the debtor was the intended recipient of the policy's proceeds and, therefore, has a claim to the proceeds. See, e.g., In re Stinnett, 465 F.3d 309, 313 (7th Cir. 2006) ("[t]he overriding question ... is whether the debtor would have a right to receive and keep those proceeds when the insurer paid on a claim"). For this reason, proceeds of first-party policies (such as fire, casualty and theft) are typically deemed the property of the bankruptcy estate since the debtor-insured is the intended recipient of the proceeds. See In re SN Liquidation, Inc., 388 B.R. 579 (Bankr. D. Del. 2008).
In contrast, proceeds from a debtor-insured's liability policies are generally not the property of the bankruptcy estate since they are payable to third parties and not to the debtor. See, e.g., Landry v. Exxon Pipeline Co., 260 B.R. 769 (Bankr. M.D. La. 2001) A significant exception to the above rules has been created where the protection of third parties with claims against the debtor-insured is at issue, such as "mass tort" cases (e.g., asbestos coverage actions) where the exposure far exceeds the insurance coverage. Courts have demonstrated a willingness in such cases to treat the proceeds of the insured's liability policies as property of the bankruptcy estate to be earmarked for holders of claims covered by the policies. See, e.g., MacArthur Co. v. Johns-Manville Corp., 837 F.2d 89 (2d Cir. 1988). Treating the proceeds in this way comports with the strong bankruptcy policy in favor of equal treatment of similarly situated claimants.
Automatic Stay
Upon the filing of a bankruptcy case by the insured, the automatic stay provisions set forth in the Bankruptcy Code are immediately triggered. See 11 U.S.C. § 362(a). Among other things, the automatic stay bars certain collection activities by creditors, including: (1) the commencement or continuation of proceedings against the debtor; (2) the enforcement of judgments against the debtor or property of the bankruptcy estate, obtained before the commencement of the bankruptcy case; and (3) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the bankruptcy case. See 11 U.S.C. § 362 (a)(1), (a)(2), (a)(6). Of course, Section 362 also provides that a party can move to lift the automatic stay and proceed against certain property subject to the automatic stay on the basis that it "is not necessary to an effective reorganization." 11 U.S.C. § 362(d)(2).
The "automatic stay" extends to actions by insurers of the debtor seeking a declaration regarding coverage obligations, if any, unless permission is first sought and obtained from the bankruptcy court. While the automatic stay typically applies to the debtor and the property of the bankruptcy estate - including the proceeds of any policies comprising the estate - where a third party claim is involved and that claim is covered by an insurance policy, the bankruptcy court will often will lift the automatic stay and allow the claim to proceed in another forum. In deciding whether to lift the stay and permit litigation to move forward outside the bankruptcy case, courts will consider a number of factors, such as whether lifting the stay would result in a partial or complete resolution of the issues; the lack of any connection with the bankruptcy case; whether the debtor's insurer has assumed full responsibility for defending it; whether the action primarily involves third parties; and the interests of judicial economy. See In re Curtis, 40 B.R. (Bankr. D. Utah 1984).
Treatment of Self- Insured Retentions
Depending upon the size of a company and the nature of its business - and corresponding liability exposure - significant self-insured retentions (SIRs) are sometimes used to defray insurance premium expenses. Indeed, in these times of corporate belt-tightening, companies may try to improve profitability by increasing their SIRs. The bankruptcy of such companies will likely impact their ability - and even their obligation - to satisfy the applicable SIR before coverage must be provided under a liability policy.
Courts have held that a debtor-insured's inability to pay its self-insured retention does not excuse the insurer from payment of amounts in excess of the retention. See, e.g., Admiral Ins. Co. v. Grace Industries, Inc., 2009 WL 2222369, No. 06-CV-02955 (E.D.N.Y. July 23, 2009) (affirming the bankruptcy court's ruling that insurer had duty to defend and indemnify insured for claims in excess of the SIR regardless of whether funded the portion of the claim within the SIR). However, while coverage may be triggered absent payment of the self-insured retention, an insurer is not obligated to pay the amount within the self-insured retention in the absence of a "drop down" provision in the policy agreeing to do so. See, e.g., Home Ins. Co. v. Hooper, 691 N.E.2d (Ill. App. Ct. 1998).
Whether coverage is available under an insurance policy where an insolvent insured is unable to pay the SIR applicable to a covered claim may have far-reaching implications, as insurers will potentially find themselves left "holding the bag" in the face of claims that would otherwise not impact - or only minimally impact - the policy. As such, due diligence may be advisable when faced with a renewing policyholder's request to increase its SIR.
Conclusion and Practical Considerations
In the wake of the current global economic crisis, consumer and corporate bankruptcies continue to rise sharply. As a result, insurers are more likely than ever to find themselves litigating coverage issues in the unfamiliar forum of bankruptcy court. One key to a successful outcome is early retention of coverage counsel knowledgeable in both insurance and bankruptcy matters. It is also important, in evaluating the potential exposure from a given loss, to have an understanding of the nature and significance of the claims being asserted, whether the insured's solvency may be in question, and whether an adverse outcome might force the insured into reorganization or liquidation.
