Mass Torts Committee

Volume 3, Number 4 / August 2005

In This Issue:

• The Effect of Bankruptcy on Insolvency Clauses in Insurance Policies: De Facto Pre-emption of State Law or the Mother of All Direct Action Statutes?
• The Next Round in Asbestos “Prepacks”: Are We There Yet?

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The Effect of Bankruptcy on Insolvency Clauses in Insurance Policies: De Facto Pre-emption of State Law or the Mother of All Direct Action Statutes?

Part 1 of 2

by Leonard P. Goldberger Esq., Stevens & Lee PC, Philadelphia1

For two aspects of the law that have always had to co-exist, bankruptcy and insurance have never quite managed to get along very well. To this day, it is still an uneasy fit—especially in mass tort bankruptcy cases where insurance coverage is often the most important asset. Indeed, after more than 20 years of dealing with asbestos bankruptcy cases, courts are still wrestling with the threshold issue of whether insurers even have standing to be heard in their policyholders’ bankruptcy cases.

One of fuzzier intersections of bankruptcy and insurance law is the effect of a bankruptcy discharge on the so-called insolvency clause that is contained in just about every insurance policy.

This article will explore this uneasy fit. Part 1 will examine the insolvency clause and discuss the need for certain claimant creditors of the bankrupt policyholder to seek relief from a bankruptcy discharge. Part 2 will consider whether the effect of bankruptcy is a de facto pre-emption of otherwise applicable state law on this insurance contract obligation or the mother of all direct action statutes.

A Typical Problem

A typical example of the tension between bankruptcy and insurance in a chapter 11 case will help put the problem in context.

Consider the following: A chapter 11 debtor is subject to pre-petition tort claims that would otherwise be covered by an existing primary liability insurance policy. Prosecution of the claims was, of course, stayed by the automatic stay. The insurance policy contains a deductible that obligates the debtor-insured to pay the first portion of a covered claim up to a specified dollar amount. As such, the insurer holds a contingent, unliquidated claim for any portion of the deductible amount that it might have to advance on behalf of its debtor-insured. The tort claimant has filed a proof of claim.

A reorganization plan is confirmed under which the holder of the tort claim, like other unsecured creditors, receive pennies on the dollar. The plan provides for a typical discharge injunction under §§524 and 1141 of the Bankruptcy Code, and for the bankruptcy court to retain jurisdiction to enforce the provisions of the plan. The insurance policy, as property of the estate, is re-vested in the reorganized debtor.

Following confirmation, the tort claimant seeks to collect the balance of its unsatisfied claim from the debtor’s insurer resulting in the following three-way conundrum:

1. “I want my money,” says the tort claimant, and points to the insolvency clause in the insurance policy, maintaining that under applicable state law it has the right to have its covered claim paid by policy proceeds notwithstanding the debtor-insured’s insolvency. Further, under bankruptcy law itself, §524(e) provides that the debtor-insured’s discharge does not relieve the insurer’s independent contractual liability to pay the otherwise covered claim.
2. “Sorry,” says the reorganized debtor-insured, but the tort claimant is bound by the discharge injunction in the confirmed plan, and it is now enjoined from asserting the claim against its insurance policy that, as property of the estate, has now re-vested in the reorganized debtor. However, in a magnanimous gesture, the reorganized debtor-insured will stipulate to relief from the plan’s discharge injunction if the tort claimant agrees to limit recovery on its claim to the extent of available insurance, and that the reorganized debtor will not incur any further costs or financial obligations.
3. “Not so fast,” says the insurer. It reminds the reorganized debtor-insured of its continuing obligation under the insurance policy to cooperate in the defense of the claim and not voluntarily agree to any payment. It maintains that any agreement to waive the benefit of the discharge injunction will breach those obligations and relieve the insurer of its coverage obligations for that claim under the policy. (And don’t forget about the additional monetary obligation for the deductible if the tort claimant is permitted to prosecute its claim and coverage is otherwise triggered.)

What a mess. Surely enlightened bankruptcy jurisprudence will lead us out of this darkness because, as the distinguished jurist Sir Edward Coke once observed, “The known certainty of the law is the safety of all.”

The Insolvency Clause

The text of the typical insolvency clause as it appears in primary liability policies is as follows:

Bankruptcy or insolvency of the insured or of the insured’s estate will not relieve us of our obligations under this Coverage Part.2

The purpose of the insolvency clause is remedial in nature, protecting an injured party from further injury of a financial nature due to the insolvency of the insured tortfeasor. The bankruptcy of an insured is not intended to provide a means for an insurer to escape liability.3

Under a pure indemnity policy, as opposed to a liability policy, where an insured is required to actually pay a claim before his insurer becomes liable for payment, the insured’s insolvency would preclude liability on the part of the insurer.4 If an insured under an indemnity policy was insolvent so that an injured party could not satisfy a judgment against that insured, the insurer in effect would be released.5 An insolvent insured who has not satisfied a judgment against it has suffered no damage and there is, therefore, no loss for the insurer to indemnify.6 Incorporation of the insolvency clause into all policies eliminates this distinction between a true indemnity policy and a true liability policy when an injured party has an unsatisfied judgment against an insolvent insured.

One of the earliest applications of such a condition was analyzed by the U.S. Supreme Court in 1925.7 The Supreme Court analyzed §109 of the Insurance Law of New York requiring that

no policy of insurance against loss or damage resulting from … injury suffered by … [a] person and for which the person insured is liable … shall be issued or delivered to any person in this state … unless there shall be contained within such policy a provision that the insolvency or bankruptcy of the person insured shall not release the insurance carrier from the payment of damages for injury sustained or loss occasioned during the life of such policy, and stating that in case execution against the insured is returned unsatisfied in an action brought by the injured … because of such insolvency or bankruptcy, that then an action may be maintained by the injured person … against such [insurer] under the terms of the policy for the amount of the judgment in the said action not exceeding the amount of the policy.8

The Supreme Court interpreted this §109 to provide that direct recovery by the injured party against the insurance carrier “shall take place only when the insured proves insolvent or bankrupt, and leaves the injured person to pursue his judgment against the insured if solvent without reliance on the policy.”9 The Supreme Court held that such a provision did not deprive the insurance company of its property without due process of laws10 or conflict with bankruptcy law by providing for an unlawful preference.11 Many jurisdictions have codified a similar requirement as listed in this statutory sources chart highlighting some of these statutes and representative case law interpreting such provisions.

Relief From Discharge Injunction

A discharge injunction arises in connection with a confirmed plan pursuant to §§524 and 1141 of the Bankruptcy Code. 11 U.S.C. §§524(a); 1141(d). To the extent that a holder of a claim covered by insurance must bring a court proceeding in order to recover from the debtor’s insurers, relief from the discharge injunction may be necessary. While it is generally agreed that a debtor’s discharge does not affect a debtor’s insurer’s liability,12 the law is uncertain as to whether relief from the discharge injunction must be sought and the conditions under which courts will permit such modification.13

Some courts have held that actions that do not seek to recover a debt “as a personal liability of the debtor” are not within the scope of the discharge injunction and, accordingly, actions against the debtor as a nominal defendant are permitted.14 Others have allowed modification of the discharge injunction conditioned on a waiver of the tort claimant’s right to collect from the debtor and/or assurance that the debtor will not be forced to incur additional expenses.15

This latter requirement may conflict with ongoing obligations of the debtor-insured to pay deductibles, self insured retentions, allocated shares of defense costs and/or other expenses under terms of any insurance policies that continue in full force and effect following confirmation. Understandably, insurers do not want the costs of satisfying the debtor-insured’s ongoing monetary obligations under the policies shifted to them following confirmation. Indeed, to the extent such claims are characterized as a debtor-insured’s pre-petition unsecured obligations, insurers themselves may be precluded from asserting such monetary claims as they arise by virtue of the plan’s release and discharge injunction. Further, insurers that seek administrative expense treatment for such, admittedly, contingent and unliquidated claims often meet with stiff resistance from reorganized debtors and bankruptcy courts who are likely to brush them aside by estimating them at zero. This is particularly so in liquidating reorganization cases where the liquidating debtor wants certainty and finality with respect to its remaining monetary obligations.

In practice, consideration of a reorganized debtor-insured’s possible post-confirmation monetary obligations under the policies is rarely included in any feasibility analysis. Without some reserve for such possible policy-related costs, reorganized debtors are likely unprepared for such unanticipated expenses and, naturally, bankruptcy courts are protective against any modification of the discharge injunction that might burden a fragile reorganization effort. Moreover, to avoid the problem of unfunded policy-related monetary obligations altogether, insurers may also claim that any consensual relief from the discharge injunction by the debtor-insured may give rise to defenses to coverage that would preclude any possible recovery by tort claimants.

Therein lies the problem: under what conditions will courts modify the discharge injunction in a confirmed plan so as to not render a covered claimant’s rights under an insolvency clause a hollow remedy? If a court will not grant a claimant relief from the discharge injunction to obtain a judgment against the debtor-insured as a predicate for triggering coverage under an insurance policy, then bankruptcy law has effected a de facto preemption of otherwise applicable state insurance law. If, on the other hand, §524(e) opens the door for covered claimants to sue insurers of bankrupt policyholders without the debtor-insured having to satisfy otherwise applicable policy terms as a condition to having an insurer provide coverage, then bankruptcy law may be used as a national, super-direct action statute by creating a greater set of rights than otherwise available under applicable state law. As will be discussed in part 2 of this article, the resolution of this conflict is governed as much by lore as by law.