The Impact Of Potential Bankruptcies On Insurer Rights And Obligations
August, 2010
I. Introduction
The Gulf Oil Spill will likely lead to a slew of small and mid-sized businesses along the Gulf Coast seeking shelter in bankruptcy court, many without enough cash or customers to make reorganization a reality. At present, the primary liability focus is on corporations that were directly involved in the operations leading up to the blowout and spill, or who manufactured the now-destroyed blowout preventer. The continuing investigation into the Gulf Oil Spill, however, is likely to result in claims against other, smaller businesses, that had indirect involvement in the drilling operations, or who manufactured components used or incorporated in the blowout preventer or other aspects of DEEPWATER HORIZON's drilling operations, or who are alleged to have negligently performed cleanup efforts or exacerbated the impact of the Gulf Oil Spill through their acts or omissions. The catastrophic nature of the Gulf Oil Spill damages could overwhelm the ability of these smaller businesses to continue normal operations. There is even talk that BP could seek bankruptcy protection if the environmental and liability claims against the oil giant continue to grow. Much of the oil spill's impact on local businesses is months if not years away, as it often takes anywhere from 12-36 months for an increase in bankruptcy filings to appear in areas affected by large disasters.
This expected increase in bankruptcy filings will undoubtedly have significant implications for liability, property and D&O insurers. Virtually all businesses carry insurance and these policies may be considered a source of funds when businesses seek bankruptcy protection. The following are just a few of the insurance-related questions that may arise from Gulf Oil Spill-related bankruptcy filings:
• Is the insurance policy or its proceeds property of the bankruptcy estate?
• Does the insurer have a continuing right to enforce policy deductibles and self-insured retentions; or conversely, does the insured's bankruptcy filing effectively require the insurer to "drop down?"
• What are the insurer's rights to participate in any bankruptcy claims resolution procedures and any settlements implicating coverage?
• Does the insurer have standing to object to reorganization plans which include measures which the insurer believes violate policy provisions or are otherwise detrimental to the insurers' economic position?
• What are the procedures that an insurer must follow in a bankruptcy proceeding to conduct the investigation or discovery necessary to evaluate and effectively resolve a debtor's claim for coverage?
• Does the insured's bankruptcy filing affect the ability of an insurer to assert a setoff against a debtor's claims against the Oil Pollution Act fund or BP Escrow Fund or Oil Spill Liability Trust Fund?
• When does an insurer need to file a proof of claim against the estate of the debtor in order to protect its interests?
• Can the insurer pay defense costs under a D&O policy without bankruptcy court approval?
Navigating these issues can be challenging for those unfamiliar with the bankruptcy and insurance landscape and requires sophisticated knowledge of bankruptcy law as well as the rights and obligations of insurers.
II. The Bankruptcy Code
The central theme of the Bankruptcy Code is to give the honest debtor a financial "fresh start."1 This is accomplished through the bankruptcy discharge, which releases the debtor from personal liability for specific debts and prohibits creditors from taking action against the debtor to collect on those debts. Upon discharge, the debtor is no longer liable for debts incurred before the bankruptcy petition, unless the debt is non-dischargeable under § 523 of the Code. The nature of the debtor's discharge depends on under which chapter of the Bankruptcy Code the debtor files. In general, there are two types of relief: liquidation under Chapter 7 and reorganization under Chapter 11 or 13.
Chapter 7 is used to liquidate the debtor's assets and distribute the property to the debtor's creditors. In a Chapter 7 case, the trustee - not the debtor - controls the process. A bankruptcy court grants a discharge after the period for filing objections to the discharge by the trustee and the creditors has expired. Generally, Chapter 7 cases are utilized by individuals with "no assets." A company may also file under Chapter 7, however, there are no exemptions and there is no discharge.
Chapters 11 and 13 "reorganize" the debtor and provide for a creditor repayment plan. Chapter 13 - the reorganization process used by individuals - grants the debtor a discharge when his or her plan of reorganization is completed. Under Chapter 13, regular income above an allowance for reasonable and necessary living expenses is used to fund a repayment plan. The debtor keeps all assets, regardless of exemptions, but agrees to turn over a portion of future earnings for a minimum of three years. Once the plan is confirmed, all property of the estate is vested in the debtor.
Conversely, a debtor who files under Chapter 11 is discharged when the plan is confirmed, rather than completed. A business often uses Chapter 11 to "reorganize" and increase profitability. Chapter 11 may also be used to liquidate a business or sell it as a going concern. In a Chapter 11, the debtor (referred to as the debtor-in-possession) has the exclusive right to file a plan of reorganization for the first 120 days of the bankruptcy. This period is commonly extended by the court. After this period, any party in interest may file a plan. The plan provides for the discharge of debt arising before the date of plan confirmation. Once the court confirms the plan, the debtor emerges as a reorganized entity. This new entity usually exits bankruptcy with a reduced debt load and an increased chance at profitability.
III. The Intersection of Insurance Coverage Issues and the Bankruptcy Process
A. Property of The Estate: Policy vs. Policy Proceeds
In order for a bankruptcy court to exercise jurisdiction over an insurance policy, it must first find that the policy is property of the debtor's estate. The Bankruptcy Code defines property of the estate broadly, to include "all legal or equitable interests of the debtor in property at the time of the commencement of the case."2 As a general rule, insurance policies are considered property of the estate. And because an insurance policy is a contract, affording the debtor certain rights under the policy, any rights the debtor has against its insurer will likely be property of the estate as well. There is a distinction, however, between the insurance policy and its proceeds. Before policy proceeds are considered property of the estate, the debtor must prove that it has a legal right to payment of the proceeds. Unless the debtor has a legally cognizable claim to the insurance proceeds and demonstrates that the policy proceeds paid by the insurer would be available to the estate's creditors, the proceeds are not property of the estate.
B. First-Party Policies
Proceeds from a first-party policy - a policy where the insurer has a direct duty to indemnify the insured for its direct loss - are generally considered property of the bankruptcy estate. For example, if the debtor-insured's property or business suffered damage as a result of the Gulf Oil Spill, and assuming the debtor-insured made a claim under its policy and coverage existed, then the policy proceeds would be payable to the debtor-insured for the benefit of the bankruptcy estate.
Because the proceeds from a debtor-insured's first-party policy are considered "property of the estate," they are also protected by the automatic stay. The automatic stay is a statutory device that operates as a stay of the commencement or continuation of any proceeding against the debtor that was or could have been commenced prior to the filing of bankruptcy.3
C. Third-Party Liability Policies
Unlike proceeds from a first-party policy, proceeds from a third-party policy - a policy where the insurer agrees to make payments to third-parties when the insured is found liable - are generally not considered property of the bankruptcy estate because the debtor-insured generally has no legally cognizable interest in or claim to the policy proceeds. Although a debtor-insured may have an interest in having its insurer pay for the debtor's wrongdoing, it is not a legal or equitable interest in the property used to pay the claim.
Because the proceeds from a debtor-insured's liability policy are generally not "property of the estate," they are also not protected by the automatic stay. This is critically important in direct-action states, as a claimant may continue its proceeding directly against the insurer without delay. In the majority of states that do not have direct-action statutes, however, because a claimant would first need to obtain a judgment against the debtor-insured, a claimant would be required to initially seek relief against the automatic stay before proceeding with its claim.
D. Director and Officer Liability ("D&O") Policies
The Gulf Oil Spill has created an environment ripe for litigation against the directors and officers of those corporations whose acts or omissions are alleged to have contributed to the Gulf Oil Spill or exacerbated its impact. To the extent that a corporation's liability exposure to the Gulf Oil Spill causes it to seek bankruptcy protection, coverage issues under D&O policies are likely to be implicated.
D&O policies differ from general liability policies in a number of significant respects, complicating the resolution of D&O coverage issues in a bankruptcy setting. A D&O policy is purchased by the corporation for the benefit of the directors and officers covered by the policy. In addition to providing liability coverage for directors and officers, a D&O policy often provides indemnification to the corporation for any payment made on behalf of its directors and officers for claims against them. The insurer generally has no duty to defend. And while the insurer may be obligated to advance defense costs, individual officers or directors are responsible for retaining defense counsel. A D&O policy will also likely contain numerous exclusions for directors and officers who committed criminal or fraudulent acts.
While a D&O policy may be considered property of the estate, the policy proceeds generally are not.4 However, where the D&O policy provides indemnity coverage to the corporation in addition to direct liability coverage to the directors and officers, the policy proceeds will likely be considered property of the estate. This is because any payment of a loss will eat away at the policy proceeds otherwise available to the debtor for claims it may have based on indemnification. Property of the estate issues are magnified when the D&O policy contains a single limit of coverage for both directors and officers and indemnification for the corporation. Because the proceeds are commingled, it is likely that all the policy proceeds would be considered property of the debtor-insured's estate. This has the potential to create significant tension between the estate of the debtor and the directors and officers of the corporation, with the D&O insurer sometimes caught in the middle.
Directors and officers facing Gulf Oil Spill liability claims may demand advancement of defense costs under the D&O policy. Conversely, the estate of the debtor may in turn object to the advancement of defense costs on the grounds that such advancement will diminish a significant asset of the estate. In these situations, the D&O insurer may need to obtain approval of the bankruptcy court before advancing any defense costs.
IV. The Bankruptcy Court as the Resolution Mechanism for Gulf Oil Spill Claims: Where Does the Insurer Fit In?
As discussed above, corporations confronted with massive numbers of lawsuits arising from the Gulf Oil Spill may ultimately seek bankruptcy protection. Filing for Chapter 11 bankruptcy protection allows a corporation breathing room to evaluate the claims against it and to formulate a resolution plan which allows it to emerge from bankruptcy as a going concern. In these situations, the issues arising from the intersection of bankruptcy proceedings and Gulf Oil Spill insurance coverage claims are likely to parallel in some respects the issues arising from what is often generically referred to as "asbestos bankruptcies;" that is, bankruptcy filings by corporations faced with tens or even hundreds of thousands of asbestos liability claims. Where tort liability exposure is the driver of the bankruptcy filing, liability insurance policy proceeds often constitute the largest alleged asset of the bankruptcy estate, and the bankruptcy plan of reorganization can have a profound impact upon the rights and obligations of liability insurers.
In tort-driven bankruptcies, claims resolution procedures are often established through the bankruptcy plan of reorganization to deal with current and future claims. Insurance proceeds are often a significant, if not the primary, source of funding for the claims resolution process. As reflected in some of the more contentious asbestos bankruptcies, the importance of the insurance "asset"5 to the reorganization process often spawns contentious coverage litigation within the bankruptcy proceeding itself, or results in proposed plans of reorganization that severely prejudice the rights of insurers, including overriding certain policy terms. Insurers may face efforts to assign their policies to a claim trust, notwithstanding anti-assignment clauses in their insurance policies. Bankruptcy courts have often overruled insurer objections to such assignments. Equally prejudicial is the acquiescence by debtors to tort creditor demands for creation of trust distribution procedures that allow claim recovery without the need to satisfy those evidentiary thresholds or proof burdens which exist in the tort system, thereby significantly increasing the potential exposure of the liability insurer. Proposed plans of reorganization may also contain findings regarding the reasonable valuation of the debtor's collective tort liability. These findings, while superficially relating only to whether the plan of reorganization is appropriate, are often used by the reorganized debtor after the fact as an alleged conclusive determination of underlying liability, so as to prevent the insurer from litigating whether the claims valuations in the bankruptcy process are reasonable for insurance coverage purposes. Accordingly, it is imperative that insurers actively monitor Gulf Oil Spill bankruptcies involving their insureds, and take all necessary steps to intervene in or influence the reorganization process so as to maximize the "insurance neutrality" of the same.
The recent ASARCO LLC bankruptcy, the largest environmental liability bankruptcy in United States history, may provide a more insurer-friendly template for addressing corporate bankruptcies driven by Gulf Oil Spill liability exposure. The debtor in ASARCO, in consultation with the unsecured creditors' committee, the various environmental claimants and the bankruptcy court, employed Bankruptcy Code § 502(c)'s streamlined process for the estimation of environmental claims. Section 502(c) authorizes the bankruptcy court to estimate contingent and unliquidated claims, particularly if the fixing or liquidation would "unduly delay the administration" of the bankruptcy case. Pursuant to this estimation process, ASARCO paid approximately $1.8 billion in restoration and cleanup costs for water, land and air pollution at 100 sites across the United States. This estimation process removed trial lawyers from the process, skirted years of potential delays, and considerably reduced overall costs.
Learning Point
Bankruptcy filings involving the insurer raise many complex and challenging questions for liability, property and D&O insurers. It is essential that the insurers retain counsel adept in navigating the intersection between bankruptcy and insurance law.
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1 Local Loan v. Hunt, 292 U.S. 234, 244 (1934).
2 11 U.S.C. § 541(a).
3 11 U.S.C. § 362.
4 But see In re Minoco Group of Cos., Ltd., 799 F.2d 517 (9th Cir. 1986) (finding D&O policies were property of the estate because they protected against diminution of the estate's value.).
5 Typically, a bankruptcy court would find that the proceeds of a liability policy are not property of the estate. But, this is not necessarily the case if the court is confronted with a corporate debtor that is subject to thousands of claimants and a limited pool of assets. The bankruptcy court, relying on its equitable powers, may find that insurance policy proceeds are necessary for the debtor's reorganization, and therefore, property of the estate.
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