Many businesses forced to close due to COVID-19 have turned to insurance to recover resulting losses. Even in the best of times, businesses face myriad challenges, and insurance is an important backstop. For a struggling company, however, insurance may be a much-needed source of funds. Similarly, for those pursuing claims against a struggling company, insurance may be the best, if not only, source of any recovery. With a surge of anticipated bankruptcy filings, both bankruptcy and non-bankruptcy attorneys need to be aware of how a bankruptcy affects insurance.
The Corporate Insured’s Perspective
Bankruptcy Should Not Affect The Insurer’s Obligations: Corporations that are already cash-strapped 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 the insurer’s obligations are not affected by an insured’s bankruptcy. For example, most liability and other policies typically contain the condition that the “[b]ankruptcy or insolvency of the insured or of the insured’s estate will not relieve [the insurer] of our obligations under [the policy].” In fact, state laws often require policies to contain such provisions. Thus, for example, an insurer is still obligated to pay for a defense of third-party litigation for a bankrupt corporation. Similarly, a bankruptcy should not affect the insurer’s obligation to pay for first-party losses.
Policy vs. Policy Proceeds: Are They Part of the Bankruptcy Estate?: The insurance policy itself will typically be considered part of the bankruptcy estate. 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 pursuant to 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, and if a bankrupt corporation pursues and recovers such proceeds, they 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, and not the corporation, the proceeds may be found to be outside the bankruptcy estate because the bankruptcy estate has no interest in the policy proceeds. This may be a particularly important issue for individual serving on corporate boards, who are expected to be targets in COVID-19-related litigation.
Where both individual directors and officers and the corporate debtor have a right to the policy proceeds, the proceeds may be part of the bankruptcy estate. Also, where the debtor has coverage for litigation expenses paid on behalf of the directors and officers, the proceeds may be part of the estate. 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 whether the proceeds are part of the bankruptcy estate.
Jurisdictional Issues: “Core” and “Non-core” Proceedings: 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 is one that would arise only in bankruptcy, it is typically a core proceeding. If the proceeding does not invoke a substantive right created by federal bankruptcy law and is one that 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 need to consider whether any coverage lawsuit is a part of the bankruptcy court’s core jurisdiction that must be litigated within the bankruptcy case, or whether it can be decided outside that context. Courts are split as to whether insurance coverage proceedings are core or non-core proceedings. There may be both practical and strategic reasons in each case as to where the coverage issues are decided. For example, some commentators perceive bankruptcy courts as inclined to preserve or expand the debtor’s estate, and therefore a forum adverse to insurers under certain circumstances.
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 its deductible or retention? 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 is not a breach of the policy. Indeed, particularly where the policy provides (as it does in most cases) that the insured’s bankruptcy does not relieve the insurer of its obligations, a self-insured retention provision should not contradict or trump this condition. Some courts, however, have held that payment of the self-insured retention is a condition precedent to coverage under the policy. And although coverage may be triggered absent 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 in the policy requiring this result. 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’s Perspective
Insurance policies are also a valuable asset to those with claims against an insolvent company. Where 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, the bankruptcy context presents unique challenges for third parties seeking to recover from a bankrupt corporation’s insurer.
The Automatic Stay: When Does it Apply? The automatic stay is one of the bedrock principles of bankruptcy law. It stays any pending legal proceeding against the debtor and prevents the filing of new claims or counterclaims against the debtor. But does the automatic stay preclude a third party from pursuing the policy proceeds of a bankrupt insured? While the automatic stay applies to policy proceeds that the debtor has an interest in, 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 should be permitted to continue in another forum. Some of these 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 with or interference with the bankruptcy case. The burden of proof on a motion to lift or modify the stay rests with the movant (the party that made the motion) to show cause, and then shifts to the debtor to establish that it is entitled to the continued protection of the bankruptcy court. The decision of whether to lift the stay, however, is within the discretion of the bankruptcy judge.
Impact of Section 524’s Discharge of Liability: The discharge of the debtor’s liability provided by Section 524 of the 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 debtor suffers little prejudice when they are sued by plaintiffs 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 the foregoing 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. This rule may change, however, when the insured is bankrupt, as many state statutes permit direct actions in this circumstance. In other states, however, the third party must first obtain a judgment against the bankrupt insured before it proceeds directly against an insurer. Attention to these and other procedural requirements is necessary to the successful recovery of policy proceeds.