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 2 of 2
by Leonard P. Goldberger Esq.
Stevens & Lee P.C., Philadelphia
Introduction1
Part 1 concluded with the question: 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 in an insurance policy a hollow remedy? The answer – more lore than law – appears to depend on how courts balance the competing interests of the various parties under the circumstances of the particular case. (This should not come as a surprise to anyone familiar with the willingness of bankruptcy courts to exercise broad equitable powers in aid of reorganization.) In the absence of guidance at the circuit court level, however, the resolution of the conflicting policies underlying bankruptcy and insurance law is likely to continue on a case-by-case basis.
Let’s return to the problem in Part 1 and play out the dynamics and outcomes of the competing arguments that the bankruptcy court will have to face. We assume, for discussion sake, that counsel for the tort claimant has the good sense to file the appropriate motion for relief from the discharge injunction in the first instance. (Even so, insurers are not always served with tort claimants’ motions for relief from discharge injunction and, as a practical matter, may not have the opportunity to interpose objections and defenses.) To unilaterally proceed to sue the reorganized debtor would be exceedingly risky and would likely result in the tort claimant ending up on the wrong end on a contempt motion. This is not a good way to begin a request to the bankruptcy court for extraordinary relief.
De Facto Pre-emption of State Law
If the bankruptcy court denies the tort claimant relief from discharge injunction, it effectively nullifies a state law right designed to provide an independent remedy for just such a situation. Moreover, it would contravene an explicit federal policy, as incorporated into §524(e), that limits the effect of a bankruptcy discharge against nondebtor third parties. In effect, keeping the discharge injunction in force as to those who, arguably, should not be bound by its technical breadth creates a supplemental injunction. While bankruptcy courts certainly have the equitable power under §105(a) to issue supplemental injunctions in aid of reorganization, there is a well-defined body of law that circumscribes the exercise of such power.2 This should be familiar to those who have participated in mass tort or asbestos-related bankruptcy cases. Some showing of necessity to the reorganization effort, however, is generally required before the confirmation order is entered. Most garden-variety chapter 11 cases would not justify the issuance of such supplemental injunctive relief simply to deal with occasional (as opposed to mass) tort claimants.
In the event that the bankruptcy court discretionarily refuses to modify the discharge injunction, the tort claimant is effectively denied its remedy of access to the insurance coverage that state law expressly provides should be available in the event of the debtor-insured’s insolvency. The reorganized debtor and its insurer are the clear winners and, indeed, may even enjoy a windfall; the tort claimant is the loser as a result of this contradiction. As such, by denying relief from the discharge injunction, the bankruptcy court will have effectively written the insolvency clause out of the insurance policy and effected a de facto pre-emption of otherwise applicable state law.
The Mother of All Direct-action Statutes
If, on the other hand, the bankruptcy court grants the tort claimant relief from the discharge injunction to give effect to the insolvency clause, applicable state law and the policy underlying §524(e), it may create a far greater set of rights by facilitating direct access to insurance coverage that would not otherwise exist. This depends principally on whether the bankruptcy court will require the reorganized debtor-insured to satisfy otherwise applicable policy terms and conditions, thus leaving the insurer-insured relationship intact.
If the reorganized debtor-insured has no further obligations under its policy, it is likely that the bankruptcy court will simply grant relief from the discharge injunction. In such an instance, neither the reorganized debtor nor the insurer is any worse off. As long as the tort claimant is only authorized to name the debtor in a lawsuit for the technical purpose of entering judgment, the reorganized debtor suffers no adverse economic effect. Similarly, if the insurer has no monetary claims against the reorganized debtor-insured that arise on account of the assertion of the tort claim, relief from the discharge injunction imposes no greater burden than if bankruptcy had not intervened. The problem occurs where the insurer asserts claims for monetary (and non-monetary) performance against the reorganized debtor-insured arising from policy obligations triggered by the post-confirmation assertion of a covered claim.
Relief from the discharge injunction can be particularly unfair if the bankruptcy court will not level the playing field by respecting and/or preserving an insurer’s ability to enforce performance of the reorganized debtor-insured’s reciprocal policy obligations, monetary or otherwise. Reorganized debtors, typically, assert that their discharge in bankruptcy precludes their insurers from asserting claims for deductibles, self-insured retentions and/or other monetary obligations under their insurance policies.3 To the extent that the discharge in the confirmed plan releases the reorganized debtor-insured’s continuing obligations to the insurer under the policy, the symmetry of the reciprocal insurer-insured relationship (as defined by the terms and conditions of the policy) is broken. In this respect, the post-bankruptcy operation of the insolvency clause as a direct-action statute may be enhanced beyond that which might otherwise be available had the insured not gone through bankruptcy.
The flip side of an insurer’s set of monetary rights under the policy is the reciprocal cost of performance of such obligations to the reorganized debtor. These costs could include, without limitation, payment of deductibles, self-insured retentions, allocation of shares of defense costs and/or other expenses under the terms of the policy that are payable on a claim-by-claim basis. Such claims, which remain inchoate during the pendency of the bankruptcy case, become due and owing once the post-bankruptcy assertion of the underlying tort claim triggers coverage the policy. A lopsided outcome may result if the insurer must satisfy its policy obligations, i.e., defending and indemnifying the reorganized debtor-insured against the otherwise-covered claim, but is deprived of the benefit of the economic (and risk-shifting) bargain that is the underlying basis of the reciprocal insurer-insured relationship.
The allocation of the reorganized debtor-insured’s ongoing monetary obligations under the policy may very well be the tipping point in the bankruptcy court’s analysis. If the primary concern is not burdening the reorganized debtor with such monetary obligations (which could be quite substantial in the event of a large loss and where the policy provides, for example, a $250,000 deductible), the bankruptcy court must decide whether or not to shift the economic burdens. It could shift them to the insurer by denying the insurer the ability to enforce such policy-related monetary claims against the reorganized debtor-insured, or to impose them against the tort claimant by directing a reduction of the judgment amount or allowing the insurer a credit against any amounts otherwise due under the policy. Such judgment reductions and/or credits may serve as the functional equivalent of having a reorganized debtor-insured satisfy its monetary obligations under the policy that arose in connection with its tender of the covered claim to the insurer. This latter result, of course, can be achieved consensually and is often the negotiated outcome of initially contested matters.
Insurers would be well-advised to anticipate resistance by the bankruptcy court to allowing their post-confirmation monetary claims against a reorganized debtor. Indeed, the failure of an insurer to file a proof of claim in the first instance may open the door to an argument that its ability to assert claims for performance of monetary obligations that relate to a pre-petition policy is time-barred. Accordingly, insurers should file proofs of claim during the pendency of the bankruptcy case in order to preserve the right to assert contingent, unliquidated claims for policy-related obligations that must necessarily be asserted post-confirmation.
The combined effect of relief from the discharge injunction coupled with the discharge of the insurer’s ability to enforce the reorganized debtor-insured’s policy obligations creates a greater set of rights that the tort claimant can assert directly against the insurer. In this respect, even a judgment reduction and/or credit arrangement will not cure the problem when, either by express policy language or applicable state law, the insurer is entitled to have the reorganized debtor-insured actually pay its monetary obligations under the policy as a condition precedent to the insurer’s obligation to pay covered claims. Indeed, the effect of the bankruptcy discharge (as may be interpreted by an unsympathetic state court4) may preclude the insurer from asserting these defenses in a subsequent coverage litigation filed in response to the tort claimants’ direct action to garnish the proceeds of the policy in satisfaction of any judgment it might obtain.
The reorganized debtor-insured’s monetary obligations under an insurance policy are not the only ones to affect the outcome of the defense of a covered claim. The reorganized debtor-insured will likely also take the position that even the non-monetary obligations under the policy are likewise discharged. This will leave the insurer without the ability to enforce the reorganized debtor-insured’s cooperation in the defense of the claim, or to prevent the voluntary agreement to pay the claim, such as by the reorganized debtor-insured’s consenting to the tort claimant’s relief from the discharge injunction in the first instance. If so, the discharge injunction would be an absolute defense to the tort claim that the reorganized debtor-insured could waive with impunity and without a consequential loss of coverage by a breach of the cooperation clause in the typical policy. As such, an insurer may be hamstrung in its attempt to assert coverage defenses based on failure of the reorganized debtor-insured’s performance of non-monetary policy obligations in subsequent coverage litigation when the tort claimant attempts to garnish the policy proceeds in order to enforce any judgment obtained. Even if these coverage defenses are still available to the insurer, it is certainly an inferior remedy to having the reorganized debtor-insured satisfy its continuing, reciprocal policy obligations before a judgment on the underlying tort claim is entered. Any bankruptcy–related abridgement of the insurer’s rights acts as an involuntary modification of the terms and conditions of the policy, and creates a “zero sum” situation where, in the face of the insolvency clause, the insurer’s loss is the claimant’s gain. To this extent, the adverse effect of the bankruptcy discharge on the insurer results in the insolvency clause creating a direct-action right of frighteningly increased potency.
Conclusion
When confronted with the decision of whether to grant relief from the discharge injunction, the bankruptcy court must attempt to reconcile the conflicting underlying policies of bankruptcy and insurance law. In the absence of any controlling guidance, bankruptcy courts are likely to continue to deal with this issue on a discretionary, case-by-case basis. (Getting any type of uniformity among bankruptcy courts in this fuzzy intersection of bankruptcy and insurance law would be like herding cats in any event.) The outcome of the decision will determine whether bankruptcy has rendered the insolvency clause a hollow remedy by a de facto pre-emption of state law, or a jacked-up, national direct-action statute by providing to claimants a greater set of rights against insurers than would otherwise be available under state law had bankruptcy never occurred.
Footnotes
- This publication is intended as a general guide only. It does not constitute legal advice of Stevens & Lee P.C. or any member of the firm with respect to the legal issues described. The opinions expressed herein are those of the author and not necessarily those of the firm. We recommend that readers not rely on this general guide in structuring transactions in which they are involved, but that they seek specific, professional advice.
- See, e.g., In re Dow Corning Corp., 230 F.3d 648, 658 (6th Cir. 2002) (imposing seven factors to be satisfied before a bankruptcy court can enjoin a nonconsenting creditor’s claims against a nondebtor). See, also, 11 U.S.C. §524(g) (imposing detailed restrictions on the issuance of supplemental injunctions in asbestos-related bankruptcy cases).
- See In re Jason Pharmaceuticals Inc., 224 B.R. 315, 317 (Bankr. D. Md. 1998).
- See Susan N. K. Gummow, Bankruptcy and Insurance Law Manual: The Basics of Insurance Law for the Bankruptcy Professional and the Basics of Bankruptcy Law for the Insurance Professional (2004) (regarding the failure of a debtor-insured to satisfy its monetary obligations under the policy, “[i]nsurance companies should be cognizant of the fact that the benefits of bankruptcy are designed to benefit the debtor, and the insurer is not the intended or residual beneficiary of the relief provided by the bankruptcy court. An insurer cannot attempt to avoid its obligation as provided in the insurance policy solely because the insured is in bankruptcy.”
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