Bankruptcy and Insurance – New Appleman on Insurance Law Library Edition, Chapter 107

By Susan N. K. Gummow and Eric J. Shukis

Abstract

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The filing of bankruptcy impacts the debtor-insured, its insurers, and parties asserting claims that may implicate the debtor’s insurance policies.  Chapter 107 introduces some of the basic elements and concepts of bankruptcy law, which are a necessary foundation to understanding how bankruptcy affects insurance as an asset of the bankruptcy estate and how other insurance-related issues are dealt with in bankruptcy. 

At its core, the Bankruptcy Code balances the need to afford the “honest but unfortunate debtor” with a fresh financial start against the need to protect the rights of creditors.  Chapter 107 begins by providing a general overview of the structure of the Bankruptcy Code and the primary forms of relief it authorizes, which are denominated by chapter: Chapter 7, Chapter 11, and Chapter 13.  Each of these

Chapters is supplemented by Chapters 1, 3, and 5 of the Code, which provide rules and provisions that are generally applicable to all bankruptcy cases.  For example, although Chapter 7 of the Bankruptcy Code provides for liquidation of both individual debtors’ assets and the assets of business entities, Chapters 1, 3, and 5 also impact cases arising under Chapter 7.

Chapter 7 provides for the most conventional type of bankruptcy relief.  Under Chapter 7, a  trustee is appointed to take control of all of the debtor’s assets, liquidate them, and distribute the proceeds to creditors.  Individual debtors are permitted to keep some small portion of their assets as “exempt property” so that they are not left completely destitute by the bankruptcy process.  Business entities that file Chapter 7 receive no exemptions, however; all of their assets are available to the trustee for liquidation.

Chapter 11, which is used almost exclusively by business entities, allows a debtor to restructure its debts by filing a “plan of reorganization.”  The debtor’s plan, which must meet numerous requirements, is voted on by the debtor’s creditors.  If the plan receives sufficient creditor support, it is approved (“confirmed”) by the bankruptcy court.  Following confirmation of the plan, all of the debtor’s creditors (even those that opposed it) are bound by its terms with respect to debts owed to them.  Chapter 11 is designed to provide flexibility to the debtor, and thus it also authorizes the debtor to use a plan to complete a sale of assets, free and clear of the interests of all creditors.  Chapter 11 also authorizes the debtor to liquidate and wind down its business (similar to a Chapter 7 case, but with the debtor remaining in control throughout the liquidation process). 

Chapter 13 allows individual debtors to enter into a three-to-five year repayment plan, whereby they pay a portion of their income each month to their creditors and receive a discharge of all remaining debts after making all required payments.  Individuals whose income exceeds certain legislatively-selected thresholds are required to file Chapter 13, rather than undertake a conventional Chapter 7 liquidation.

Section 107.01[3] and [4] consider the means by which a bankruptcy case is filed and address the roles of the various participants to bankruptcy cases.  Bankruptcy cases can be commenced voluntarily or involuntarily.  While the great majority of bankruptcy cases are filed voluntarily, the Bankruptcy Code does provide a mechanism for creditors to force a debtor into bankruptcy.   

One of the key players in bankruptcy cases is the Office of the United States Trustee, which is part of the Department of Justice.  The U.S. Trustee oversees all bankruptcy cases that are filed, and is responsible for assigning and supervising the private (i.e., not government employees) trustees that administer Chapter 7 and Chapter 13 cases.  In Chapter 11 cases, the U.S. Trustee plays a more active role, monitoring the reorganizing debtor for compliance with all aspects of the Bankruptcy Code and appearing in court to object, as necessary.

The debtor – while certainly a key player in all bankruptcies – occupies a role that varies in significance depending on the chapter of bankruptcy that was filed.  In Chapter 11 cases, the debtor is extremely active, because it remains in complete control of the bankruptcy case.  No trustee is appointed; instead, the debtor exercises the powers of a trustee, and is referred to as the “debtor-in-possession” or “DIP.”  In contrast, a Chapter 7 debtor plays a rather passive role in the bankruptcy process.  Once the debtor has filed the bankruptcy petition, a trustee is assigned to collect, liquidate, and distribute the proceeds of the debtor’s property.  The debtor can object to any improper actions of the Chapter 7 trustee, but the trustee’s powers and authority is broad. 

The role of creditors of the debtor varies depending on the creditor’s pre-bankruptcy rights.  Creditors that have a consensual lien on the debtor’s assets – such as banks – are referred to as “secured creditors.”  The bankruptcy process does not affect the property interests of non-debtors, and because a lien is an interest in property, the lien “secures” these creditors’ right to payment notwithstanding the filing of bankruptcy. 

In bankruptcy, secured creditor status provides many advantages.  For instance, secured creditors are entitled to payment before unsecured creditors are paid.  They may also be entitled to payments as “adequate protection” if the debtor-in-possession or trustee continues to use the property securing the creditor’s claim.  Additionally, the debtor’s plan cannot be approved by the court if it does not meet certain special requirements regarding the treatment of secured claims.

Any creditor with a perfected interest  in the debtor’s property is a secured creditor to the extent of the value of its lien.  Thus, creditors that hold a judgment against the debtor and have perfected their judgment creditor rights may also be secured creditors.  Insurers are secured creditors to the extent they hold a perfected interest in collateral provided by the debtor (possession of collateral constitutes a perfected interest under Article 9, which applies in most states). 

Creditors without a lien or other perfected security interest are “unsecured creditors.”  These creditors have little power in bankruptcy on an individualized basis.  However, the bankruptcy process is focused on equitable treatment of unsecured creditors as a group, and thus unsecured creditors maintain a key role in all bankruptcy cases.  In Chapter 11 cases, the mechanism for protection of the unsecured creditors’ interests is formalized by the creation of an Official Committee of Unsecured Creditors, which is a group of creditors appointed by the U.S. Trustee.  In cases where there is no committee, the U.S. Trustee bears the burden of protecting the rights of unsecured creditors, although any unsecured creditor may appear and be heard on issues pertaining to unsecured creditors generally.

The role of the debtor’s insurers is also addressed in Chapter 107.  Insurers frequently occupy a dual role in bankruptcy.  They are often a creditor of the debtor, on account of premiums owed, or other amounts that are due to be paid by the debtor-insured.  As a creditor, the insurer’s rights are no different than any other creditors’ rights.  If they are a secured creditor, they will receive full payment to the extent of the value of the property securing the debt.  If the insurer is an unsecured creditor, it will likely receive little or nothing on account of its claim.

Importantly, insurers occupy another role in bankruptcy as well – as a counterparty to a contract with the debtor.  Contracts – including insurance policies – cannot be modified by the debtor-insured, even though it has filed bankruptcy.  In this role, the insurer’s rights are significantly more robust, as discussed throughout this chapter and in Chapters 108 and 109.

Section 107.01[5] continues by discussing several foundational aspects of bankruptcy and  explaining some of the important events that occur soon after the commencement of a bankruptcy case, including the first meeting of creditors, and the setting of a claims bar date.  Section 107.01[6] deals with bankruptcy court jurisdiction, which is complex.  As explained in Section 107.01[6][a], this complexity is primarily the result of certain constitutional limitations on the power of bankruptcy judges.  Bankruptcy judges, who derive their authority from Article I of the Constitution, do not exercise the same type of judicial authority that other federal judges do under Article III of the Constitution.

To avoid problems with constitutionality, bankruptcy jurisdiction is vested in the federal district courts, rather than the bankruptcy courts.  Each district court then automatically “refers” all bankruptcy matters to the bankruptcy judges for that district.  Bankruptcy law categorizes these proceedings into three groups: proceedings that “arise under” the Bankruptcy Code, those that “arise in” a bankruptcy case; and those that are “related to” a bankruptcy case.  Bankruptcy judges have full authority over these first two types of proceedings, which fall within the “core” jurisdiction of the bankruptcy court.  With regard to “related to” proceedings, the bankruptcy court’s jurisdiction is circumscribed, given that these matters frequently have only an attenuated relationship to the bankruptcy case, and thus are “non-core.”  Non-core matters cannot be fully and finally determined in the bankruptcy court (absent consent of the parties); the district court must enter any final order or judgment. 

The morass that is bankruptcy jurisdiction can affect insurance-related issues because insurance-related disputes are not unique to bankruptcy, and thus often fall outside of the “core” jurisdiction of the bankruptcy court.  Where jurisdiction is lacking, parties may seek to move the entirety of a dispute from the bankruptcy court to the district court by moving for withdrawal of the “reference” that placed the matter before the bankruptcy judge for adjudication in the first place.  This permits a determination of disputes that are merely “related to” bankruptcy by a district court judge that has the full constitutional power of the judiciary.

Section 107.01[6] also addresses issues with removal of proceeding from non-bankruptcy courts to the bankruptcy court, and the bankruptcy court’s ability to remand those proceedings for cause.  It also addresses abstention, which is a process by which a bankruptcy court can decline to hear matters over which state law issues predominate.

Section 107.02 turns to a discussion of the consequences and legal effects of a debtor’s bankruptcy filing.  At the moment the debtor-insured’s petition is filed, a “bankruptcy estate” is created.  This estate is comprised of all of the property previously belonging to the debtor.  The estate serves as a fund out of which the debtor’s creditors will be paid. 

“Property of the estate” is construed broadly.  All of the debtor’s legal and equitable interests in property are “property of the estate,”  including rights under contracts, such as insurance policies.  As discussed in Chapter 108, however, the estate does not reach property the debtor has no interest in prior to bankruptcy, and as applied to the proceeds of insurance policies this rule can have significant implications.

The bankruptcy estate is further limited with respect to individual debtors by the “exemptions” permitted by the Bankruptcy Code.  A debtor can remove or “exempt” certain property from the bankruptcy estate.  By permitting exemptions, the Code prevents the bankruptcy process from making individual debtors utterly destitute.

Section 107.02 also introduces the automatic stay of bankruptcy.  Upon the filing of the bankruptcy petition, an injunction or stay immediately goes into effect, applicable to all persons and entities.  This stay prohibits all attempts to collect debts owed by the debtor, including the commencement or continuation of judicial, legal, or administrative proceedings.  It also prohibits non-judicial attempts to collect debts owed by the debtor.  The automatic stay is discussed extensively in Chapter 109 given the numerous insurance-related matters that are impacted by it.

Section 107.02[6] examines claims and creditors.  Generally, there are three types of claims in a bankruptcy case: secured claims, priority unsecured claims, and general unsecured claims.  A claim that is secured by a lien on property is considered a secured claim.  Secured claims enjoy the highest level of priority in a bankruptcy case, and are paid before any unsecured claims receive payment.  Creditors without security for repayment of the debts owed to them are “unsecured” creditors, and these creditors usually receive payment for only a small portion of the debts owed to them.

The claims of certain unsecured creditors are given “priority,” however, for policy reasons.  The foremost priority in Chapter 11 cases goes to “administrative expenses,” such as the debtor’s attorneys’ fees and other necessary costs of the reorganization process, such as post-petition insurance for the debtor’s ongoing operations.

Section 107.02[7] examines the concept of discharge.  A debtor who successfully completes the bankruptcy process receives a discharge of the unpaid balance of remaining obligations. Discharge serves as a permanent injunction against any attempts to collect from the debtor on any discharged debts.  Importantly, however, the discharge is personal to the debtor.  Furthermore, discharge does not eliminate the debt.  Thus, discharge does not affect any other entities’ liability for the debt, including insurers. 

Section 107.02[7][b] examines exceptions to discharge.  Despite the general rule that the debtor’s bankruptcy culminates in a discharge of remaining liabilities, the Bankruptcy Code provides a number of exceptions.  If a debt is deemed non-dischargeable, it remains a collectible liability of the debtor after the bankruptcy case is complete. 

Section 107.03 examines bankruptcy “standing” – the concept of what parties may appear and be heard at the various stages of the bankruptcy process.  Claimants seeking recovery from the debtor’s insurance policies are usually “general unsecured creditors,” and thus have standing to object to those aspects of the bankruptcy that affect this creditor group.  The standing of insurers in bankruptcy is more nuanced.  While insurers generally have standing to raise matters that directly affect them, there are instances where the standing of the debtor’s insurer may be limited.  Among other things, limitations are imposed where insurers seek to participate in bankruptcy appeals.

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Susan N.K. Gummow is a partner in the Chicago office of Foran Glennon Palandech Ponzi & Rudloff, P.C., where she handles business-related matters including bankruptcy, business litigation, and insurance law.  She has extensive experience representing insurance companies confronted with a full array of bankruptcy issues and is the author of several publications, including the BANKRUPTCY AND INSURANCE Law MANUAL, currently in its third edition.

Eric J. Shukis is an associate in the Chicago office of Foran Glennon Palandech Ponzi & Rudloff, P.C., where he handles restructuring and insolvency-related matters, insurance coverage, and commercial litigation

The authors would like to thank John P. Eggum for his valuable assistance in the drafting of this chapter.

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Table of Contents

§ 107.01 Basics of Bankruptcy

[1] Introduction to Bankruptcy

[a] The Purposes and Sources of Bankruptcy Law

[b] Structure of the Bankruptcy Code

[2] Different Kinds of Bankruptcy Cases

[a] Chapter 7 – Liquidation

[b] Chapter 11

[i] Conventional Chapter 11 Reorganizations

[ii] Sale of Assets Outside the Chapter 11 Plan

[iii] Small Business Reorganizations

[iv] Liquidation

[c] Chapter 13 – Individual Reorganizations

[3] Voluntary Versus Involuntary Bankruptcy Cases

[a] Voluntary Cases

[b] Involuntary Cases

[i] Purpose Behind Involuntary Petitions

[ii] Filing Requirements

[iii] Standard of Proof

[4] Key Players in a Bankruptcy Case

[a] The Role of the U.S Trustee

[b] The Debtor – How Chapter 7 Compares to Chapters 11 and 13

[c] The Official Committee of Unsecured Creditors

[d] Insurers

[e] Secured Creditors

[f] Unsecured Creditors (Including Tort Claimants)

[5] Key Dates and Documents in a Bankruptcy Case

[a] Petition Date

[b] First Meeting of Creditors

[c] Proof of Claim

[d] Claims Bar Date

[e] First Day Motions and Orders

[f] Schedules of Assets and Liabilities

[6] Bankruptcy Jurisdiction

[a] Historical Background

[b] Statutory Bases for Bankruptcy Court’s Jurisdiction

[i] Jurisdiction Is Vested Initially in the District Court, and Then “Referred” to the Bankruptcy Court

[ii] Proceedings “Arising Under,” “Arising in,” and “Related to” Bankruptcy Cases

[iii] The Three Types of Proceedings That a Bankruptcy Court Can Hear Are Then Further Divided Into “Core” and “Non-core” Proceedings

[A] “Core” Versus “Non-core” Proceedings Generally Distinguishes Bankruptcy Matters From Non-bankruptcy Matters

[B] Traditional Core/Non-core Issues Can Directly Affect Whether Policy Issues Are Determined by a Bankruptcy Court

[iv] Stern v. Marshall and Its Affect on “Core” Proceedings

[A] Procedural History of Stern

[B] Stern’s Impact on “Core” Proceedings

[c] Withdrawal of the Reference From District Court Allows a Non-bankruptcy Matter to Be Heard in a District Court

[i] Permissive Withdrawal Affords the District Court Discretion to Evaluate Whether Withdrawal of the Reference Is Appropriate

[ii] Some Matters May Require Mandatory Withdrawal From the Bankruptcy Court

[d] Removing a Claim or Cause of Action to the District Court

[e] Seeking Abstention of the Bankruptcy Court

[i] Permissive Abstention

[ii] Mandatory Abstention

[f] Venue

[g] A Bankruptcy Court Retains Jurisdiction Post-confirmation Over Certain Matters

[h] Bankruptcy Appeals

§ 107.02 General Principles of Bankruptcy Law

[1] Determining the Property of the Estate Is an Important First Step in Gathering up All of the Insured’s Assets

[2] Property of the Estate Will Include an Insurer’s Policy, and Possibly Proceeds of the Policy

[3] Exempt Property

[a] The Code Allows a Debtor to Exempt Certain Property From Distribution to Its Creditors

[b] A Debtor May Be Entitled to Insurance Proceeds for Exempt Property That Suffers a Loss Post-petition

[4] The Automatic Stay of Bankruptcy and How It Operates

[5] Creditors and Claims

[a] Claim Defined

[b] Secured Claims

[i] Treatment of Secured Claims Under the Bankruptcy Code

[ii] Types of Secured Claimants

[A] Insurers

[B] Loss Payees/Mortgagees

[C] Premium Finance Companies

[c] Priority Unsecured Claims

[i] How Priorities Work

[ii] Administrative Expense Claims

[A] Purpose of Administrative Expenses Is to Encourage Creditors to Voluntarily Deal With the Debtor-in-Possession

[B] Two-part Test for Determining Whether a Creditor Holds an Administrative Expense Claim

[C] Insurance-Related Administrative Expenses

[D] Surcharging a Secured Lender for Insurance-Related Obligations

[iii] Insurers are Not Entitled to an Administrative Expense Under the Provisions Relating to Priorities for Contributions to Employee Benefit Plans

[d] General Unsecured Claims

[e] Certain Pre-petition Insurance Premiums That an Insurer Receives May Be Subject to a Preference Action by Either the Trustee or the Debtor-in-Possession

[6] Discharge of the Debtor’s Liability

[a] Overview

[b] Certain Claims Are Non-dischargeable and Therefore Remain Enforceable Against the Debtor After Bankruptcy

[c] Procedure for Excepting a Particular Claim From Discharge

[d] Understanding the Difference Between Complaints Objecting to Dischargeability vs. Complaints Objecting to Discharge

[e] Claims Against Debtors Serving in a Fiduciary Capacity

§ 107.03 Insurer Standing in Bankruptcy Proceedings

[1] Standing at the Trial Level

[2] Standing at the Appellate Level

[3] Proceedings in Bankruptcy Cases Where Insurer Standing Issues Have Arisen

[a] Insurer Objecting to Claims Filed Against the Debtor’s Estate

[b] Insurer Contesting the Debtor’s Retention of Special Litigation Counsel

[c] Insurer Objecting to a Plan’s Confirmation

[d] Insurer Seeking to Reopen Their Insured’s Bankruptcy Case         

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