An insured party that files for bankruptcy receives the protection of the automatic stay under 11 U.S.C. § 362(a). The automatic stay bars proceedings to recover claims against the debtor and collection against property of the debtor’s estate, giving the debtor breathing room to liquidate or restructure its debts. With few exceptions generally inapplicable to tort claims, the stay effectively halts civil actions against the debtor-insured, putting litigation deadlines, mediation, and voluntary settlement negotiations on hold.
Although the stay may offer insurers a welcome respite, bankruptcy can dramatically change the claims landscape. Pending tort claims generally follow one of two paths: the debtor agrees to relief from the stay so plaintiffs can liquidate their claims to judgment and pursue only available insurance proceeds, or the debtor opposes relief and proposes to treat the claims under a bankruptcy plan. This article explains bankruptcy’s goals and how each path may affect insurers. Understanding these dynamics is increasingly important as financially distressed businesses seek resolutions through bankruptcy.
Bankruptcy’s Purpose: The Discharge
A business debtor may file a bankruptcy petition for many reasons. Most commonly, outstanding debts are due and the debtor cannot refinance or otherwise resolve its obligations to creditors. Other filings may be more strategic. A debtor may wish to sell a substantial portion of its business under U.S. Bankruptcy Code provisions that permit assets to be sold free and clear of liabilities pursuant to Section 363(f). Similarly, a debtor facing numerous litigation claims across the country may seek to consolidate those proceedings in a single, manageable forum.
Whatever the reason, the general goal of a bankruptcy filing is the same: to limit the debtor’s obligation to pay debts. The U.S. Bankruptcy Code allows debtors to accomplish this goal in a few ways. A business debtor most commonly seeks to limit the debtor’s liability by filing a Chapter 11 case. In Chapter 11, a debtor typically pursues one of two paths: proposing a plan that restructures debts and permits continued operations, or liquidating assets and establishing a mechanism to wind up its affairs. In either scenario, the goal is a discharge. A discharge under the U.S. Bankruptcy Code enjoins creditors holding claims as of the petition date from pursuing those claims except as provided in the court-approved plan. Once the court confirms a bankruptcy plan, creditors generally may receive only the treatment the plan provides and are enjoined from pursuing additional amounts from the post-bankruptcy entity.
The effect of the discharge is that the post-bankruptcy entity is no longer personally liable for obligations to prepetition creditors. Eliminating personal liability advances one of bankruptcy’s primary goals: giving the debtor a fresh start. It does not, however, eliminate an insurer’s obligation to provide coverage for prepetition claims. This premise is based on Section 524(e) of the U.S. Bankruptcy Code, which provides that a discharge does not affect the liability of any non-debtor entity related to the same debt. Consistent with that provision, courts permit claimants to proceed against a discharged debtor in name only to establish liability as a prerequisite to recovery from insurance. (See In re Jet Florida Systems, 883 F.2d 970 (11th Cir. 1989)).
The Role of Insurance in Bankruptcy
Although insurance products vary, their primary purpose is to respond to claims when the debtor-insured is the beneficiary of coverage. Claims may be adjusted and handled in the ordinary course, although obtaining bankruptcy court approval before disbursing policy proceeds may be prudent. Other claims arise from losses alleged by third-party claimants against the insured. Policy proceeds explicitly for the benefit of third parties may not constitute property of a bankruptcy debtor’s estate. The automatic stay does not apply to non-estate property. However, the automatic stay pauses trials, settlements, and similar proceedings against a debtor, which prevents a third-party claimant from liquidating a claim to judgment.
Many states require policies to include language providing that the insolvency or bankruptcy of the insured does not eliminate an insurer’s obligations under the policy. Because the bankruptcy discharge does not eliminate an insurance carrier’s contractual duty to respond to potentially covered claims, insurance remains an important component of a business bankruptcy proceeding. A discharge, or the expectation of one, nevertheless shifts the dynamics between the debtor-insured and the insurer. The debtor-insured may retain contractual obligations to satisfy policy conditions even though the confirmed plan has effectively limited its liability for prepetition claims. A debtor-insured that retains a contract in bankruptcy generally takes it with its burdens as well as its benefits under 11 U.S.C. § 365. Insurers, which are often the target of plaintiffs’ groups, therefore should recognize how the bankruptcy case may affect their exposure.
Relief From the Automatic Stay
When a debtor faces a handful of claims, the debtor may agree to modify the automatic stay to permit a claimant can liquidate a claim against the debtor “in name only” and pursue available insurance proceeds. In such cases, the parties may stipulate that the debtor’s liability is limited to the treatment provided under a plan or that the debtor has no liability at all.
Defense of Claims
Carriers may ultimately need to decide whether to defend claims to avoid defaults. Bankruptcy can leave a carrier defending claims without access to the witnesses, employees, and records necessary to mount a defense. If the debtor is liquidating, key employees may no longer be available to assist. The debtor may also have received permission to destroy records and data rather than continuing to pay storage costs, causing evidence preservation issues. Control of management or operations may pass to restructuring officers, court-appointed trustees, or wind-down trustees who have no knowledge of prepetition events. Policies commonly provide that the insurer has the right and duty to defend claims against the insured to which the policy applies. Depending on the policy’s terms and conditions, a carrier may therefore face the unenviable task of defending claims to avoid a default judgment that could attach to insurance proceeds, while confronting obstacles that do not arise outside bankruptcy.
Deductibles and SIRs
Deductibles and self-insured retentions (SIRs) create different challenges in bankruptcy. If a deductible requires the insurer to pay from the first dollar and seek reimbursement from the insured, the insurer likely will hold only an unsecured claim for that reimbursement. Even with a timely proof of claim, the insurer generally will not recover the claim’s full value unless it holds collateral securing the deductible obligation. With an SIR, the challenge instead often arises in settlement negotiations: the insurer is not required to drop down and pay judgments within the SIR, but the claimant may demand greater damages to reach insurance proceeds above the SIR. (See In re Keck, Mahin & Cate, 241 B.R. 583, 596 (Bankr. N.D. Ill. 1999).
Litigation Trusts
When a debtor-insured uses bankruptcy to consolidate numerous litigation claims, the plan may create a litigation trust to preserve assets for claimants, value claims, and distribute trust assets. In such cases, the debtor-insured often vests the trustee with the right to pursue insurance coverage regardless of anti-assignment provisions. For coverage purposes, the trustee effectively steps into the shoes of the debtor-insured.
Litigation trusts operate under the confirmed plan and the trust agreement. A plan often includes trust distribution procedures designed to assess the validity of claims, apply a valuation matrix, and establish percentage-based distributions to claimants. The trust process can create challenges for insurers in determining how the process interacts with policy terms and conditions. The ordinary insurance claims process relies on an interested insured to help defend claims. Under the trust process, there may be little or no opportunity to defend or rebut claims, and the procedures may permit recovery on claims that would otherwise be barred by statutes of limitations or other defenses. As a result, claim values may become inflated.
Insurance policies also commonly require an approved settlement or judgment before the insurer is obligated to pay. A claim value established through trust distribution procedures without the insurer’s input likely does not constitute an approved settlement. Nor would such a value likely constitute a judgment establishing an obligation to pay. Accordingly, the policy’s conditions precedent to coverage may not have been satisfied. Insurers, however, are not without a voice. In Truck Insurance Exchange v. Kaiser Gypsum, 602 U.S. 268 (2024), the Supreme Court held that an insurer with financial responsibility for bankruptcy claims is a “party in interest” entitled to object to a Chapter 11 plan. Plan proponents often respond by invoking the “insurance neutrality” doctrine, developed in Third Circuit Court of Appeals case law, and argue that the plan leaves the insurer’s rights and obligations unchanged and therefore there is no basis for insurer objections.
After the litigation trust determines claim values, the trust generally becomes responsible for pursuing insurance coverage. A litigation trust may also pursue extra-contractual claims based on allegations of insurer bad faith or breach of contract, with the goal of maximizing available insurance assets for litigation claimants. Insurers, therefore, may have to defend not only coverage claims but also claims for extra-contractual damages.
Bankruptcy Does Not End the Claims Process
The automatic stay pauses claims litigation without limiting an insurer’s exposure. The bankruptcy court may allow litigation to proceed, or a plan may establish a process for valuing and paying claims with the goal of utilizing insurance proceeds. These processes can increase claims-management costs by placing much of the resolution outside the carrier’s control. Carriers can better protect themselves by monitoring the bankruptcy docket for pleadings that offer insight on which path a bankruptcy case will proceed. Knowledge of relief from the automatic stay allows an insurer to prepare to defend claims from entry of default. Reviewing plan-related filings allows an insurer to participate in plan negotiations and engage in discussions about trust distribution procedures. Early engagement puts carriers in a stronger position than reacting after plan confirmation.
About the author:
Andrew Perry is a bankruptcy and insurance attorney at Perry, PLLC. aperry@perry-pllc.com