Many businesses forced to close due to COVID-19 have turned to insurance to try to recover resulting losses. For struggling companies, insurance may be a much-needed source of funds. Similarly, for those pursuing claims against a struggling company, insurance may be the best source of any recovery. As more companies continue to struggle during this economic crisis, risk professionals for both these companies and those that do business with them need to be aware of how a bankruptcy affects insurance coverage.
The Insured Perspective
Even in the best of times, insurance policies are a valuable asset, but as companies file for bankruptcy, insurance coverage becomes especially critical. The key topics that commonly arise for policyholders in bankruptcy scenarios include:
Insurer obligations. Already cash-strapped corporations can be further challenged when faced with litigation. The automatic stay triggered upon a bankruptcy filing provides some breathing room for the debtor corporation, but when litigation ensues, an insurance policy can provide additional relief. The good news is that most policies provide that bankruptcy does not relieve the insurer of its obligations under the policy. In fact, state laws often require policies to contain such provisions. Thus, an insurer is still obligated to pay for costs like a bankrupt company’s first-party losses or its defense for third-party litigation.
Ownership of policy proceeds. The insurance policy itself will typically be considered part of the bankruptcy estate. U.S. Bankruptcy Code Section 541(a) provides that the estate includes “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 estate.” Courts have found this language to include the debtor’s contract rights in insurance policies.
Most courts have drawn a distinction, however, between the insurance policies themselves and the proceeds from those policies. Whether the proceeds are considered part of the bankruptcy estate depends upon the type of policy at issue, as well as who may benefit from the policy. For example, proceeds paid from a liability insurance policy to a third party (e.g., an individual claiming he or she was physically injured as a result of the company’s actions) will likely not be considered part of the estate because the purpose of liability insurance is to protect third parties. The debtor/policyholder therefore typically has no claim to those proceeds.
On the other hand, proceeds from a first-party loss under a property policy would typically be part of the bankruptcy estate. Many policyholders are seeking business interruption losses due to forced closures resulting from COVID-19. These claims typically fall under property policies, so if a bankrupt corporation pursues and recovers such proceeds, the funds will likely belong to the estate.
The question becomes trickier with D&O insurance, which is designed to protect individual directors and officers and, under many policies, the corporation itself. D&O policies commonly cover individual directors and officers for losses that the corporation cannot indemnify, reimburse the corporation for amounts paid to indemnify the directors and officers, and may also cover the corporation for certain direct claims made against it. Where a claim is asserted only against the individual directors and officers but not the corporation, the proceeds may be considered outside the bankruptcy estate. This may be an important issue for those serving on the boards of companies that are potential targets for COVID-19 litigation.
The policy proceeds may be part of the bankruptcy estate where both individual directors and officers and the corporate debtor have a right to the proceeds and where the debtor has coverage for litigation expenses paid on behalf of the directors and officers. In short, because different policies provide different types of coverage for different insureds, and plaintiffs can assert claims against more than one insured at a time, it is important to carefully review the claims being asserted and available coverage to determine if the proceeds are part of the bankruptcy estate.
Jurisdictional issues. A bankruptcy court does not have jurisdiction to hear all disputes, and generally may not adjudicate private rights under state law. It may only hear issues that are part of its “core” jurisdiction, as well as “non-core” issues that are related to the bankruptcy case. If the proceeding would only arise in bankruptcy, it is typically a core proceeding. If the proceeding does not invoke a substantive right created by federal bankruptcy law and could exist outside of bankruptcy, it is not a core proceeding—it may be related to the bankruptcy because of its potential effect, but will likely be considered a non-core proceeding.
Insureds must consider whether any coverage lawsuit falls under the bankruptcy court’s core jurisdiction and must be litigated within the bankruptcy case or whether it can be adjudicated elsewhere. Courts are split as to whether insurance coverage proceedings are core or non-core proceedings. There may be practical and strategic reasons for jurisdictional considerations. Some bankruptcy courts, for example, may be more inclined to preserve or expand the debtor’s estate, thereby creating a forum adverse to insurers.
Payment of self-insured retentions. Many corporations reduce premiums through high deductibles or self-insured retentions that must be paid before the insurer becomes responsible for payment. But what happens if the corporate insured is bankrupt and unable to pay? In this situation, an insurer typically cannot avoid its obligations under the policy.
At least one court has found that a debtor is not required to exhaust the self-insured retention before coverage was triggered, and that the debtor’s failure to pay the retention was not a breach of the policy. Indeed, particularly where the policy provides that the insured’s bankruptcy does not relieve the insurer of its obligations, a self-insured retention provision should not preclude coverage.
However, some courts have held that payment of the self-insured retention is required for coverage. Even though coverage may be triggered without payment of the self-insured retention, the insurer may not be obligated to pay the self-insured amount where there is no specific “drop-down” provision requiring this in the policy. Perhaps in an attempt to avoid such a result and maximize insurance proceeds, some courts have suggested alternative means for satisfying the self-insured retention if necessary, such as the grant of an unsecured claim for payment of the retention.
The Third-Party Perspective
Insurance policies are also a valuable asset to those with claims against an insolvent company. If a corporate defendant has limited assets or is bankrupt, its insurance policy may be the most likely source of funds for plaintiffs seeking recovery from the corporation. But just as it does for policyholders themselves, bankruptcy also presents unique challenges for third parties seeking to recover from a bankrupt corporation’s insurer.
Application of the automatic stay. The automatic stay is one of the bedrock principles of bankruptcy law. It halts any pending legal proceeding against the debtor and prevents the filing of new claims or counterclaims against them. But does the automatic stay preclude a third party from pursuing the policy proceeds of a bankrupt insured? Most courts hold that, where a third-party claim is covered by an insurance policy, the automatic stay should be lifted and the claim allowed to proceed outside the bankruptcy case.
Courts look to a variety of factors to determine whether the stay should be lifted and litigation can continue in another forum. Such factors include whether the action primarily involves third parties, whether the debtor’s insurer has assumed full responsibility for the defense of the action, whether relief would result in a partial or complete resolution of the issues, and the strength of the connection to or interference with the bankruptcy case.
Discharge of liability. The discharge of the debtor’s liability provided by Section 524 of the U.S. Bankruptcy Code normally precludes further claims against the debtor. Importantly, however, Section 524 should not affect an insurer’s liability for a debt. Indeed, courts have recognized that the debtors can be sued primarily for the purpose of obtaining a judgment that would then allow the plaintiff to seek recovery from the debtor’s insurer.
Direct action against the insurer. Assuming obstacles are overcome and an action to recover policy proceeds is permitted, many states preclude a third party from bringing a direct action against the insurer. However, many state statutes permit such direct actions when the insured is bankrupt. In other states, the third party must first obtain a judgment against the bankrupt insured before it proceeds directly against an insurer.