What Happens to Insurance Coverage In Case of Bankruptcy?

Presented by John T. Hansen, PartnerKurt W. Melchior, Partner

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The information contained herein does not constitute a legal opinion and should not be relied uponby the reader as legal advice or be regarded as a substitute for legal advice.

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Overview

Learn what insurance is available to pay losses and to defend and indemnify for claims of creditors/injured parties.

Learn whether, how and to what extent existing insurance can be accessed by the debtor’s officers and directors.

Learn whether existing policies can be cancelled, and whether the court can order policy renewals.

Learn whether the trustee or debtor can buy “tail” coverage.

Learn what the effect is of an insured’s bankruptcy on claims for the insurer’s failure to settle.

Learn whether or not an insurer can avoid liablity coverage because of the debtor’s insolvency.

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Courts Can Enjoin Policy Cancellation

The courts have asserted the power to enjoin cancellation of insurance policies, as “essential to the power to reorganize.”

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No Right to Compel Policy Renewals

Nonrenewals of expiring insurance policies are a problem.

Carriers are often reluctant to provide insurance to financially distressed parties, while debtors almost always need liability coverages (at least) in order to reorganize successfully.

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Policy Renewals Can Be Critical to Reorganizations

Professional service providers generally cannot function without errors and omissions (professional liability) insurance. Yet, insurers generally have no duty to renew coverages.

If a substantial business is involved, there may be enough economic substance to obtain such coverages.

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Professional Liability Claims

Existing malpractice insurance coverage will be used to cover pre-petition professional liability claims.

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The Role of Bankruptcy as a Court of Equity

Equitable means will be used to provide as much coverage as possible, looking for answers wherever possible.

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Seizing Policy Proceeds

Courts may impound available policy proceeds to distribute them equitably among claimants.

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Debtor Cannot Buy Back Liability Policies Where Claims Outstanding

Under the laws of California and other states, bankruptcy courts will enjoin debtors from buying back liability policies where unliquidated claims implicating such policies exist. Claimants should watch bankruptcy dockets and protect themselves by timely objections.

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Are Post-Petition Claims Covered?

No case law we found addresses post-petition claims, except that by implication coverage is available under existing policies until their expiration date, assuming unexhausted limits.

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Bankruptcy’s Effect on Tort Claims Against Third Parties

Courts have no authority to protect bystanders, such as the physicians working in a bankrupt network, except perhaps where the same policies cover both the bankrupt and related parties.

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Bad Faith Claims

The debtor’s bankruptcy should moot bad faith claims against its insurer for post-petition conduct with respect to pre-petition claims,both by the claimant and by the debtor.

Pre-petition bad faith is a more uncertain issue.

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Buying Tail Coverage

Chapter 7 Trustee may buy tail coverage for the bankrupt, In re Lavigne; but is not required to do so, as shown by the Heller Ehrman bankruptcy.

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Claimants’ Rights Against Debtor’s Insurer

Discharge of the bankrupt does not prevent a claimant’s suit against the bankrupt’s insurer. Only the debtor is protected against discharged claims. Where the claim is to be satisfied only by the debtor’s insurance – e.g., malpractice insurance, a suit seeking only such recovery creates no diminution of the debtor’s estate, and may proceed.

even though the debtor may be the necessary, but nominal, defendant; and

even though the debtor may be required to devote time to the defense of the action.

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Enjoining Coverage Litigation

Bankruptcy courts can, but rarely will, enjoin litigation, such as coverage litigation, by non-debtors. They will do so only where there is an immediate adverse economic effect on the debtor’s estate.

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Interpreting Insurance Policies

Bankruptcy court can interpret insurance policies and grant judgment of non-coverage.

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Equitable Powers in Complex Multi-Party Insurance Litigation

In complicated cases involving many claimants, bankruptcy courts have asserted jurisdiction over non-debtors and over insured claims against related parties to avoid first come, first served races to judgment.

In such cases, courts take possession of the policies and their projected proceeds in order to oversee equitable (and presumably pro rata) distribution of the policy proceeds.

How such claims are resolved remains unclear; but the courts will seek equitable solutions.

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A Case Which Covers the Full Territory

For the fullest treatment of issues, who owns the policy and who owns the proceeds, and how to handle tort claims against the debtor, see In re Doug Baity Trucking, Inc.

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Bankruptcy Court Can Enforce Policy Terms

Insurance contract terms will (or may) be enforced in bankruptcy. Thus, where credit life insurance named the lender as the primary owner, lender was entitled to the policy proceeds to satisfy its full debt despite bankruptcy “cram down” of the debt to the secured property’s present value.

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Long Latency Tort Claims—A Special Problem

Long latency tort claims present particularly great challenges to producers and insurers in the bankruptcy context, where almost all such producers inevitably end up. If you have such problems, prepare to engage in deep study and extensive negotiations.

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Who owns the insurance policies of a debtor in bankruptcy?

This is one of the few well settled questions in this subject area. Courts agree that the estate of the debtor owns the policy, even though the debtor may not be the beneficiary. Matter of Ellsworth.

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Who owns or is entitled to obtain the proceeds of the policy when a claim is made and paid or about to be paid?

This is one of the many unsettled questions in this subject area, and the answer is a classic “It Depends.”

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It may depend on what circuit the case has been filed.

The First and Ninth Circuits appear to take the position that if the debtor owns the policy, it owns the proceeds. Hathaway Mach. Co., Inc.; In re Minoco Group of Cos., Inc.; but cf. In re Pintlar.

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Some courts hold that it depends on who are the intended beneficiaries of the policy.

The Court in Edgeworth, supra, said it depends on “whether the debtor would have a right to receive and keep those proceeds when the insurer paid on a claim.” The classic types of policies under this approach are D&O policies purchased by a corporation to insure its officers and directors from claims for actions in the scope of their employment. Louisiana World Exposition.

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Some courts holds that it depends on the nature of the policy.

When the purpose of a policy is to protect the debtor or its property from loss, then the proceeds should be part of the estate. See, Ellsworth, n. 22, listing casualty, collision, life, and fire insurance in this category.

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However, these categories readily break down as the facts change, and therefore some courts say it depends on the facts and circumstances of each case.

E.g., Matter of Vitek, Inc. [Describing a continuum in which D&O policies are at one end and policies insuring the debtor’s own liability are at the other, with some cases lying somewhere along the continuum.]; Cases falling somewhere along the continuum include situations where the debtor and a non-debtor are co-insureds, e.g., In re Reider and cases in which there are multiple claims against the debtor which exceed policy limits. E.g., In re The Taylor Agency, Inc.

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What happens to claims against the insured debtor in bankruptcy? How does an injured party make a claim?

A first principle is to realize that the commencement of a bankruptcy case triggers the automatic stay of Section 362(a) of the Bankruptcy Code. Among other things, the automatic stay:1. stays the continuation or commencement of any legal

proceedings against the debtor that had been commenced or could have been commenced prior to the filing of the bankruptcy petition. This covers actions against the debtor, even though it is insured and the carrier will defend and pay any judgment;

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(cont’d)

2. stays the enforcement against the debtor or against property of the estate of any judgment obtained against the debtor prior to bankruptcy; and

3. stays any action to obtain or exercise control over property of the estate.

4. It is clear that, without obtaining relief from the stay an injured party cannot continue a suit or commence a suit against the debtor to recover judgment for its injuries, even if the debtor is insured.

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But what if a judgment creditor wants to sue the carrier?

An injured party that obtained a judgment prior to bankruptcy may or may not be able to directly sue the carrier, even though state law may permit such an action, because the insurance policy, and in some cases the proceeds of the policy also, are property of the estate. E.g., See, Matter of Edgeworth.

A further consideration that permeates this issue is the question whether there are multiple claims against the same policy that may exceed coverage. E.g., MacArthur Co. v. Johns-Manville Corp.

In view of the above, what should the injured party do?

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No judgment obtained.

File a proof of claim with the bankruptcy court. Failure to timely file a claim could be considered a waiver of the claim. But cf. Matter of Edgeworth, supra [Failure to file a proof of claim only waives right to collect from the debtor, but not to collect from the insurer.]

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If no suit pending.

Contact Debtor’s counsel and find out if debtor will tender the claim to its carrier for payment. If carrier accepts liability, no suit may be necessary, although bankruptcy court approval may be required for payment of the claim, especially if there are likely to be multiple claims.

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If that does not work, what next?

File a motion for relief from the stay to file lawsuit. (Note: Section 108(c) of the Bankruptcy Code suspends the running of a statute of limitations until 30 days after the stay expires or is lifted, or until the end of the SOL, whichever is longer.) Several courts have developed factors for determining whether to lift the stay to permit litigation against the debtor in a non-bankruptcy forum. E.g., In re Marvin Johnson’s Auto Service, Inc. [ten factors]; In re Johnson [seven factors]; In re Curtis [thirteen factors].

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what next (cont’d)

Typical factors:a. Will the carrier pay costs of defense;

b. Will the lawsuit interfere with reorganization process;

c. Does the lawsuit involve an area of law outside bankruptcy court’s usual purview; and

d. What is the balance of harm if the lawsuit is stayed or permitted to proceed?

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If lawsuit already commenced?

File motion for relief from stay. In addition to the above factors, the bankruptcy court will consider how advanced the existing lawsuit is. The more advanced, the more likely relief from stay will be granted, especially if trial date already set.

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Judgment Obtained

a. State law may permit a judgment creditor to file a direct action against the insurer.

b. However, the automatic stay may prevent such an action; therefore relief from stay may have to be obtained before proceeding against the insurer.

c. Relief from stay ordinarily will be granted if it can be shown insurance policy proceeds are intended to cover this type of injury and claims against the proceeds do not exceed policy limits.

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Questions?

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Contact

Kurt W. MelchiorSan Francisco Office415.438.7279kmelchior@nossaman.com

John T. HansenSan Francisco Office415.438.7245jhansen@nossaman.com