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Salvaging Third Party Insurance Claims Mired in Bankruptcy

By: James H. Vorhis, Allan H. Ickowitz
12/18/08

The emerging recession is likely to bring more bankruptcies. This, in turn, will throw more claims against insurance policies into bankruptcy court. This article considers how you can best preserve your claim to insurance policy proceeds when a defendant sinks into bankruptcy.

1) Know where you stand in the litigation process

Knowing where you stand chronologically in the litigation process is critical in evaluating your ability to pursue insurance claims when a bankruptcy has been filed.

Do you already have a pre-bankruptcy judgment against the debtor in hand?

Yes. If you do, direct action statutes will almost certainly allow you to avoid the bankruptcy altogether by filing suit directly against the insurance company. Barring very complex situations such as mass tort cases, where complex coverage and allocation issues exist, stay relief should be relatively easy to obtain because the debtor will not need to expend time or money to defend your lawsuit.

No. Unless insurance proceeds are sufficient to satisfy all covered claims, courts may not grant stay relief and your lawsuit likely will have to wait until the debtor has been discharged. Courts take this stance despite the fact that proceeds are unavailable to general creditors because the lawsuit itself could hinder the debtor's ability to recover the maximum value of the policy. (See Tringali v. Hathaway Machinery Company, Inc. (1st Cir. 1986) 796 F.2d 553, 560.) But your right to prevent the application of insurance proceeds for any purpose other than paying covered claims should be deemed to exist from the moment of your injury, so you are protected from having those proceeds dissipated in the interim. (Shapiro v. Republic Indem. Co. of America (1959) 341 P. 2d 289, 290.)

2) Analyze the Policy

One of your first steps should be analyzing the debtor's policy. Is it a third party liability policy that covers only the claims of third parties like you? Is it a first party policy that reimburses the debtor/insured for its own losses? Is it a hybrid of the two? What effect will that have on coverage related to your claim? These questions, along with subsequent analysis, will inform the appropriate strategic decisions necessary to maximize your recovery.

First party indemnification policies typically inure to the benefit of the bankruptcy estate, while third party policies inure to the benefit of claimants. Although the distinction between first and third party policies is usually apparent, the line can become blurred, particularly in areas such as environmental contamination and director's and officer's coverage. Further complicating matters, courts have interpreted "reimbursement" policies in different ways.[1]

Strategically, knowing what type of policy is involved is of critical importance, particularly if the policy includes both first party reimbursement coverage and third party liability coverage with a combined aggregate limit. The law is not clear on the subject, but in those instances of a combined aggregate limit, a pro rata allocation between the two aspects of coverage may be appropriate, particularly to the extent that covered losses or liability have not been liquidated. Practically speaking, the amount available to you as a third party may be diminished by the "first come, first served" principle if the debtor incurs expenses before your claim is adjudicated.

3) If it is a Third Party Policy, Insurance Proceeds are Earmarked for You

Most courts recognize that covered third parties have a direct, equitable interest in insurance proceeds, and accordingly, the disposition of those proceeds generally has been held subject to the interests of covered claimants. Such treatment is akin to an assignment of those proceeds separate and apart from the policies themselves. (La. World Exposition, Inc. v. Fed. Ins. Co. (In re Louisiana World Exposition, Inc.) (5th Cir. 1987) 832 F.2d 1391, 1399.) The proceeds normally will be used solely to satisfy the specific beneficiaries of the estate's insured liability. If there were any other result, general creditors would receive a windfall despite having no claim that falls within the coverage of the policy. (In re Catania (Bankr. D. Mass 1989) 94 B.R. 250, 252-253, fn. 4.)

Mass tort cases with many claimants are an exception to the treatment of insurance policies described above. Courts analyzing insurance policies in such cases often consider the insurance proceeds as property of the debtor's estate. Courts have enjoined direct actions which reduce the estate's recovery from those policies in order to allow the bankruptcy estate to maximize those proceeds, and organize the distribution to covered claimants. (In re Johns Manville Corp. (S.D.N.Y. 2006) 340 B.R. 49.)

4) You are Protected from Unilateral Termination of the Policy by the Insurer

While the insurance proceeds are subject to the interests of claimants, the insurance policy itself, like other executory contracts, is an asset of the estate with value to the debtor insofar as it provides a source of payment for certain of the debtor's liabilities. Thus, it cannot be unilaterally terminated by the insurer without obtaining relief from the automatic stay. (Minoco Group of Cos. Ltd. v. First State Underwriters Agency of New England Reinsurance Corp. (In re Minoco Group of Cos., Ltd.) (9th Cir. 1986) 799 F.2d 517.)

5) Be Aware of Potential Coverage problems

There are pitfalls you need to know about when attempting to recover insurance proceeds in bankruptcy cases. Your ability to recover money for your claim may be taken out of your control in the following three situations:

    A) The Debtor and Trustee may be able to Settle with an Insurer to your Detriment in Bad Faith Cases

Bad faith insurance cases provide a "hook" to the traditional rule that insurance proceeds inure to the benefits of covered third party claimants. When bad faith claims exist between the debtor and insurance company, any recovery for that claim will be deemed a contract claim that inures to the benefit of the estate, and ultimately the general creditors. (See In re Soliz (Bankr. N.D. Tex. 1987) 77 B.R. 93.) Such claims are considered contract claims between the insurer and insured.

Despite this "hook" to the extent that the existence of the policy is not an issue, third parties with covered claims would he at least as likely to require an allocation of any settlement or recovery from the insurance company as the debtor's/trustee's contract claims and proceeds payable under the policy.

    B) The Estate may have Authority to Settle with the Insurer to your Detriment

Many courts support the proposition that the estate is entitled to negotiate and enter into settlements with insurance companies, even over the objection of covered claimants. (See e.g., In re Dow Corning Corp. (Bankr. E.D. Mich. 1996) 198 B.R. 214, 236.)

Some courts have even gone so far as to allow a Chapter 7 Trustee to approve a settlement with the debtor's insurers whereby the insurer would pay the remainder of the policy limits into the estate in return for an injunction against all potential third party actions against the carrier, with one limited exception, thereby barring all future potential third party claims. (Homsy v. Floyd (In re Vitek, Inc.) (5th Cir. 1995) 51 F.3d 530.)

However, while there are Bankruptcy Court decisions that have allowed the estate to settle with the insurer to the detriment of third party claimants, in the non-bankruptcy context the California Supreme Court disallowed such circumvention of the third party. (See Shapiro v. Republic Indemnity Company of America (1959) 341 P.2d 289, 290.)

6) What to do if the debtor fails to schedule the insurance policy, resulting in a policy that is neither abandoned nor administered

Courts will treat this situation in different ways. Some courts will reopen the bankruptcy case for the purposes of allowing a creditor to pursue the policy proceeds, while others will deem such reopening unnecessary and allow the creditor to pursue their claims after the debtor's discharge.

7) What to do if coverage litigation is pending at time of bankruptcy or initiated during bankruptcy proceedings

Normally, a solvent insured will pursue coverage disputes itself. During a bankruptcy, the same incentive remains, although the resources may be limited. Under applicable bankruptcy statutes, it is unclear to what extent the third party claimant may pursue insurance in place of an unwilling or financially unable insured. In such situations, the insured, debtor and/or trustee should consider the feasibility of creative funding arrangements to allow such litigation to move forward. This could entail funding by the injured party or a credit arrangement tied to repayment upon recovery against the insurer.

Given the complexity of the law in this area and the large number of issues on which courts taken opposing positions, clients holding third party claims against the insurance policies of a bankrupt defendant should consult with counsel to maximize their recovery.

Thomas D. Long, a member of Nossaman's Insurance Coverage Practice Group, is a Litigation Partner with over 23 years of experience. Tom represents policyholders in insurance coverage litigation claims. He can be reached at tlong@nossaman.com. Allan H. Ickowitz, Co-Chair of Nossaman's Financial Services Practice Group, is a Bankruptcy Partner with over 30 years of experience. He can be reached at aickowitz@nossaman.com. James H. Vorhis is an Associate in Nossaman's Insurance Coverage and Financial Services Practice Groups and can be reached at jvorhis@nossaman.com.



[1] (Contrast Equinox Oil Co. v. Official Unsecured Creditor's Comm. (In re Equinox Oil Co.) (5th Cir. 2002) 300 F.3d 614 (reimbursement provision only covered the debtor because the vendor/creditor could have prevented the problem by requiring that they be named as loss payees under the debtor's policy as a condition to undertaking the remediation work) to In re Doug Baity Trucking, Inc. (Bankr. M.D.N.C April 21, 2005) 2005 Bankr. LEXIS 1099 (reimbursement provision covered the debtor's liability to unknown third parties that remediated property damage caused by the debtor because the debtor had not paid the vendor, it could not be "reimbursed" under the policy).)

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