First Circuit Raises Troubling Questions

Under the insurance policy in Rosciti, the insured was required to pay the first $500,000 of any defense expenses, settlement or judgment. While the policy provided that the insured's bankruptcy did not relieve the carrier of its obligations, it also set forth that the insured's bankruptcy would not require the carrier to “drop down” or otherwise require the carrier to satisfy the insured's retention.

Because the insured had not paid the initial $500,000 prior to the filing of the bankruptcy proceeding, the carrier claimed that it had no obligation to defend the claim or pay plaintiffs. Any other outcome, it argued, would require the carrier to drop down and pay the $500,000 retention and require the carrier to defend against the lawsuit before the insured had paid its retention. The carrier complained that it did not account for these additional obligations in establishing its premium charge.

The plaintiffs conceded that the carrier was not obligated to pay the first $500,000 of any judgment or settlement, but was obligated to pay any amounts over that amount. Any other result, they argued, would ignore the policy language stating that the insured's bankruptcy would not relieve the carrier of its coverage. The plaintiffs also argued that the carrier's promise to pay even if the insured filed bankruptcy conflicted with the language that there was no coverage until the insured paid the $500,000, because the insured would never be able to pay if it was subject to a bankruptcy proceeding. Furthermore, letting the carrier off the hook if the insured filed for bankruptcy would violate the public policy behind the Rhode Island direct action statute.

The Court's View

The First Circuit held that the policy language was not in conflict. Nonetheless, if the carrier provided no coverage at all until the insured satisfied the retained limits, this would violate Rhode Island public policy requiring insurers to cover insureds in bankruptcy, as embodied in the direct action statute. The court referenced the fact that many other states have statutes that, in one form or another, prohibit insurers from making their coverage contingent on the solvency of the insured.

As to the carrier's argument that it was being asked to pay policy amounts and defense costs that were not required by the policy and had not been factored into the premium calculation, the court noted that there was no record evidence of how the premium was calculated. In any event, the policy did contemplate that the carrier would pay defense costs for claims in excess of $500,000, and plaintiffs were demanding more than that amount. Moreover, while the Rhode Island direct action statute might limit plaintiffs' recovery of any judgment or settlement to the amount of the available coverage, it does not set forth that carriers are relieved of a duty to defend claims when an insured is in a bankruptcy proceeding. Therefore, the court held that the carrier was required to provide a defense to the insured, but would only be liable for the amount of any judgment that exceeded the amount of the insured's self-insured limit of $500,000.

Interplay Between Bankruptcy and Insurance

Understanding the implications of this dispute requires some knowledge of bankruptcy law. Section 362 of the Bankruptcy Code provides that once a bankruptcy proceeding is filed, all parties, with or without knowledge of the bankruptcy proceeding, are automatically stayed from commencing or continuing any action against the debtor or the debtor's property. Thus, any action against the debtor, whether or not covered by insurance, is automatically stayed. However, bankruptcy courts routinely modify the automatic stay to permit a plaintiff to continue or to pursue an action against an insured debtor, but only to the extent of the available insurance coverage, with the understanding that any uninsured portion of the judgment will only constitute an unsecured claim in the debtor's bankruptcy estate.

It is also possible for the case against the defendant/debtor to be removed to the bankruptcy court by the debtor or the debtor's insurance carrier within 30 days after the bankruptcy case has been commenced. If the case involves personal-injury claims, the actual trial may only be handled by the district court as opposed to the bankruptcy court. Likewise, unless the parties agree to the bankruptcy court conducting a jury trial in non-personal injury matters, any jury trial must be conducted by the district court. This triggers an initial strategic decision for the debtor and its insurer ' namely, will the carrier obtain a strategic benefit by having the underlying liability determined by a bankruptcy court or is the carrier better served litigating in state court or federal district court? Although the answer depends on facts of each case, experience suggests that insurers often fare better when proceeding outside of the bankruptcy court. This is particularly true in cases involving complex coverage and/or liability issues, as bankruptcy courts are not likely to have encountered such issues with the same frequency as their state court and federal district court counterparts.

Effect on Insurers

The ruling in Rosciti has a significant impact on insurers. It creates an environment where the plaintiff's counsel will be unwilling to settle a case within the self-insured limits, as the plaintiff will then only have an unsecured claim against the debtor in a bankruptcy case. This will almost certainly frustrate any potential settlement of the claim, thereby significantly increasing the defense costs for the carrier. What is more, if the carrier is providing a defense, its only interest is to avoid any judgment or settlement above the retained limit, as it will have no responsibility below that amount. Still further, although the insurer in Rosciti did not adduce evidence that its premium was significantly based on its limited defense and payment obligations, it most likely could have made this showing.

One question is whether the outcome would be different in states where direct action against an insurance carrier is not permitted where the insured files bankruptcy. The majority of jurisdictions where no direct action statutes exist are in accord with the First Circuit's holding that the insurer of a bankrupt insured is not obligated to “drop down” and provide coverage for a judgment that falls within the ambit of the insured's deductible or self-insured retained limit. Rather, the insurer is generally only obligated to provide coverage for any judgment that exceeds the risk contractually assumed by the insured. See In re Vanderveer Estates Holding, LLC, 328 B.R. 18 (Bankr. E.D.N.Y. 2005); In re FF Acquisition Corp., 422 B.R. 64 (Bankr. N.D. Miss. 2009); Home Ins. Co. of Illinois v. Hooper, 294 Ill. App. 3d 626 (1998); and Corporation v. Aetna Casualty & Surety Company, 107 B.R. 856 (E.D. Pa. 1989).

Duty to Defend and Cost Recovery

On the defense issue, many of these courts have not required the carrier to defend the bankrupt insured. See Admiral Ins. Co. v. Grace Indus., Inc., 409 B.R. 275 (E.D.N.Y. 2009); In re Apache Products Co., 311 B.R. 288 (Bankr. M.D. Fla. 2004); In re Jet Florida Sys., Inc., 883 F.2d 970 (11th Cir. 1989). In such cases, however, carriers are faced with a proverbial Hobson's choice: either defend the claim, or face a default judgment that unquestionably would result in a larger judgment for the insurer to pay. Thus, if a plaintiff successfully petitions the bankruptcy court for modification of the automatic stay to permit an action against the insured debtor, the carrier will likely choose to defend the claim.

The First Circuit's decision also appears to leave open the question of whether the carrier is entitled to proceed against the insured to recover incurred defense costs that fall within the self-insured retained limit. Generally courts have determined that an insured's failure to satisfy a deductible or self-insured retained limit because of insolvency gives rise to a claim for breach of contract that must be pursued by the insurer in the insured's bankruptcy proceeding. See In re Firearms Imp. & Exp. Corp., 131 B.R. 1009 (Bankr. S.D. Fla. 1991); Am. Safety Indem. Co. v. Official Comm. of Unsecured Creditors, 2006 WL 2850612 (E.D.N.Y. 2006); and In re Ames Dept. Stores, Inc., 1995 WL 311764 (S.D.N.Y. 1995).

Of course, this provides little solace for the insurer as its chances of recovering the full value of the incurred defense costs as a claimant in the bankruptcy proceeding are slim. Nonetheless, to preserve any right to recovery, insurers must timely file a contingent proof of claim in the insured's bankruptcy proceeding for the value of present and anticipated future defense costs.

Rosciti highlights an insurance carrier's need to effect a financial and credit review of a prospective insured. If an insured's financial condition materially changes, insurance carriers are advised to adjust premiums at renewal. Further, in cases of marked financial deterioration, insurance carriers must assess the propriety of renewing the insured's policy in light of the inherent risk that the insured's insolvency may force the carrier to defend against liability claims ' a contingency that is rarely factored into the original premium.

Conclusion

Carriers should be mindful that even the inclusion of a bankruptcy exclusion in the insured's policy is not likely to shield the insurer from its obligation to defend a claim against an insured subject to a bankruptcy proceeding or from affording coverage for a claim that exceeds the self-insured retained limit, as such exclusions are likely void as a matter of public policy. As noted in Rosciti, many states have specifically enacted legislation mandating that liability insurance contracts include a provision that the insolvency or bankruptcy of an insured shall not release an insurer from liability. See, e.g., N.Y. Ins. Law ' 3420; Cal. Ins. Code ' 11580; 215 Ill. Comp. Stat. Ann. ' 5/388; Mich. Comp. Laws Ann. ' 500.3006.

Bankruptcy attorneys in providing pre-bankruptcy strategic legal advice to distressed business debtors need to be fully aware of the extent of insurance coverage, the extent of any self-insurance and any coverage measured against what claims may have been or may be asserted against the debtor that would be subject to insurance coverage. Too often, because of the press for time and the need for a prompt bankruptcy filing, debtors' attorneys fail to complete this very important inquiry before committing to the bankruptcy process. This is particularly true for claims that have not yet been subject to litigation, as the plaintiff may be required to file a proof of claim (because of the automatic stay) before commencing any litigation When contemplating a bankruptcy filing where these issues may be present, it is important to consult with the carrier's counsel before filing the bankruptcy proceeding to maximize strategic benefits to the insured.

All of the above demonstrates that what at first blush may appear to be a simple issue of insurance or bankruptcy law, may instead be a significant trap for the unwary.

David A. Grossbaum chairs the Insurance Services group at Hinshaw & Culbertson LLP. Practicing out of the firm's Boston and Providence, RI, offices, he handles insurance coverage matters throughout the country and defends professionals in liability cases. Charles M. Tatelbaum is a partner in the Bankruptcy & Creditors' Rights group and practices in the firm's Fort Lauderdale, FL, office. Matthew R. Watson is an attorney in the Insurance Services group and practices in the firm's Boston and Providence offices.

The recently published First Circuit opinion in Rosciti v. Insurance Company of the State of Pennsylvania , 659 F 3d 92 (1st Cir. 2011) presents an increasingly common interplay between two somewhat different and often conflicting areas of law ' insurance coverage and bankruptcy. The conflict arises when the insured has a large self-insured retention or deductible that it is obligated to pay before the insurance coverage is triggered, but prior to the entry of a judgment or settlement the insured files bankruptcy and cannot pay that obligation. When the insured/debtor has a covered claim against it, the plaintiff and the insured want the insurer to provide coverage, and the insurer's position is that it has no duty to do so unless and until the insured satisfies its initial payment obligations.

Facts

In Rosciti, purchasers acquired a mobile home manufactured by the plaintiff insured. The purchasers later sued the insured, seeking to recover for alleged defects. Thereafter, the insured filed for Chapter 11 bankruptcy protection, which under Section 362 of the Bankruptcy Code stayed the purchasers' lawsuit. The purchasers added the carrier as a defendant to the suit based upon a Rhode Island statute, R.I. Gen. Laws ' 27-7'2.4, which allows a plaintiff to sue the defendant's insurer directly if the insured defendant files for bankruptcy relief. Nonetheless, the plaintiff can only recover the amount of applicable insurance coverage from the carrier.

Under the insurance policy in Rosciti, the insured was required to pay the first $500,000 of any defense expenses, settlement or judgment. While the policy provided that the insured's bankruptcy did not relieve the carrier of its obligations, it also set forth that the insured's bankruptcy would not require the carrier to “drop down” or otherwise require the carrier to satisfy the insured's retention.

Because the insured had not paid the initial $500,000 prior to the filing of the bankruptcy proceeding, the carrier claimed that it had no obligation to defend the claim or pay plaintiffs. Any other outcome, it argued, would require the carrier to drop down and pay the $500,000 retention and require the carrier to defend against the lawsuit before the insured had paid its retention. The carrier complained that it did not account for these additional obligations in establishing its premium charge.

The plaintiffs conceded that the carrier was not obligated to pay the first $500,000 of any judgment or settlement, but was obligated to pay any amounts over that amount. Any other result, they argued, would ignore the policy language stating that the insured's bankruptcy would not relieve the carrier of its coverage. The plaintiffs also argued that the carrier's promise to pay even if the insured filed bankruptcy conflicted with the language that there was no coverage until the insured paid the $500,000, because the insured would never be able to pay if it was subject to a bankruptcy proceeding. Furthermore, letting the carrier off the hook if the insured filed for bankruptcy would violate the public policy behind the Rhode Island direct action statute.

The Court's View

The First Circuit held that the policy language was not in conflict. Nonetheless, if the carrier provided no coverage at all until the insured satisfied the retained limits, this would violate Rhode Island public policy requiring insurers to cover insureds in bankruptcy, as embodied in the direct action statute. The court referenced the fact that many other states have statutes that, in one form or another, prohibit insurers from making their coverage contingent on the solvency of the insured.

As to the carrier's argument that it was being asked to pay policy amounts and defense costs that were not required by the policy and had not been factored into the premium calculation, the court noted that there was no record evidence of how the premium was calculated. In any event, the policy did contemplate that the carrier would pay defense costs for claims in excess of $500,000, and plaintiffs were demanding more than that amount. Moreover, while the Rhode Island direct action statute might limit plaintiffs' recovery of any judgment or settlement to the amount of the available coverage, it does not set forth that carriers are relieved of a duty to defend claims when an insured is in a bankruptcy proceeding. Therefore, the court held that the carrier was required to provide a defense to the insured, but would only be liable for the amount of any judgment that exceeded the amount of the insured's self-insured limit of $500,000.

Interplay Between Bankruptcy and Insurance

Understanding the implications of this dispute requires some knowledge of bankruptcy law. Section 362 of the Bankruptcy Code provides that once a bankruptcy proceeding is filed, all parties, with or without knowledge of the bankruptcy proceeding, are automatically stayed from commencing or continuing any action against the debtor or the debtor's property. Thus, any action against the debtor, whether or not covered by insurance, is automatically stayed. However, bankruptcy courts routinely modify the automatic stay to permit a plaintiff to continue or to pursue an action against an insured debtor, but only to the extent of the available insurance coverage, with the understanding that any uninsured portion of the judgment will only constitute an unsecured claim in the debtor's bankruptcy estate.

It is also possible for the case against the defendant/debtor to be removed to the bankruptcy court by the debtor or the debtor's insurance carrier within 30 days after the bankruptcy case has been commenced. If the case involves personal-injury claims, the actual trial may only be handled by the district court as opposed to the bankruptcy court. Likewise, unless the parties agree to the bankruptcy court conducting a jury trial in non-personal injury matters, any jury trial must be conducted by the district court. This triggers an initial strategic decision for the debtor and its insurer ' namely, will the carrier obtain a strategic benefit by having the underlying liability determined by a bankruptcy court or is the carrier better served litigating in state court or federal district court? Although the answer depends on facts of each case, experience suggests that insurers often fare better when proceeding outside of the bankruptcy court. This is particularly true in cases involving complex coverage and/or liability issues, as bankruptcy courts are not likely to have encountered such issues with the same frequency as their state court and federal district court counterparts.

Effect on Insurers

The ruling in Rosciti has a significant impact on insurers. It creates an environment where the plaintiff's counsel will be unwilling to settle a case within the self-insured limits, as the plaintiff will then only have an unsecured claim against the debtor in a bankruptcy case. This will almost certainly frustrate any potential settlement of the claim, thereby significantly increasing the defense costs for the carrier. What is more, if the carrier is providing a defense, its only interest is to avoid any judgment or settlement above the retained limit, as it will have no responsibility below that amount. Still further, although the insurer in Rosciti did not adduce evidence that its premium was significantly based on its limited defense and payment obligations, it most likely could have made this showing.

One question is whether the outcome would be different in states where direct action against an insurance carrier is not permitted where the insured files bankruptcy. The majority of jurisdictions where no direct action statutes exist are in accord with the First Circuit's holding that the insurer of a bankrupt insured is not obligated to “drop down” and provide coverage for a judgment that falls within the ambit of the insured's deductible or self-insured retained limit. Rather, the insurer is generally only obligated to provide coverage for any judgment that exceeds the risk contractually assumed by the insured. See In re Vanderveer Estates Holding, LLC, 328 B.R. 18 (Bankr. E.D.N.Y. 2005); In re FF Acquisition Corp., 422 B.R. 64 (Bankr. N.D. Miss. 2009); Home Ins. Co. of Illinois v. Hooper , 294 Ill. App. 3d 626 (1998); and Corporation v. Aetna Casualty & Surety Company , 107 B.R. 856 (E.D. Pa. 1989).

Duty to Defend and Cost Recovery

On the defense issue, many of these courts have not required the carrier to defend the bankrupt insured. See Admiral Ins. Co. v. Grace Indus., Inc. , 409 B.R. 275 (E.D.N.Y. 2009); In re Apache Products Co., 311 B.R. 288 (Bankr. M.D. Fla. 2004); In re Jet Florida Sys., Inc., 883 F.2d 970 (11th Cir. 1989). In such cases, however, carriers are faced with a proverbial Hobson's choice: either defend the claim, or face a default judgment that unquestionably would result in a larger judgment for the insurer to pay. Thus, if a plaintiff successfully petitions the bankruptcy court for modification of the automatic stay to permit an action against the insured debtor, the carrier will likely choose to defend the claim.

The First Circuit's decision also appears to leave open the question of whether the carrier is entitled to proceed against the insured to recover incurred defense costs that fall within the self-insured retained limit. Generally courts have determined that an insured's failure to satisfy a deductible or self-insured retained limit because of insolvency gives rise to a claim for breach of contract that must be pursued by the insurer in the insured's bankruptcy proceeding. See In re Firearms Imp. & Exp. Corp., 131 B.R. 1009 (Bankr. S.D. Fla. 1991); Am. Safety Indem. Co. v. Official Comm. of Unsecured Creditors, 2006 WL 2850612 (E.D.N.Y. 2006); and In re Ames Dept. Stores, Inc., 1995 WL 311764 (S.D.N.Y. 1995).

Of course, this provides little solace for the insurer as its chances of recovering the full value of the incurred defense costs as a claimant in the bankruptcy proceeding are slim. Nonetheless, to preserve any right to recovery, insurers must timely file a contingent proof of claim in the insured's bankruptcy proceeding for the value of present and anticipated future defense costs.

Rosciti highlights an insurance carrier's need to effect a financial and credit review of a prospective insured. If an insured's financial condition materially changes, insurance carriers are advised to adjust premiums at renewal. Further, in cases of marked financial deterioration, insurance carriers must assess the propriety of renewing the insured's policy in light of the inherent risk that the insured's insolvency may force the carrier to defend against liability claims ' a contingency that is rarely factored into the original premium.

Conclusion

Carriers should be mindful that even the inclusion of a bankruptcy exclusion in the insured's policy is not likely to shield the insurer from its obligation to defend a claim against an insured subject to a bankruptcy proceeding or from affording coverage for a claim that exceeds the self-insured retained limit, as such exclusions are likely void as a matter of public policy. As noted in Rosciti, many states have specifically enacted legislation mandating that liability insurance contracts include a provision that the insolvency or bankruptcy of an insured shall not release an insurer from liability. See, e.g., N.Y. Ins. Law ' 3420; Cal. Ins. Code ' 11580; 215 Ill. Comp. Stat. Ann. ' 5/388; Mich. Comp. Laws Ann. ' 500.3006.

Bankruptcy attorneys in providing pre-bankruptcy strategic legal advice to distressed business debtors need to be fully aware of the extent of insurance coverage, the extent of any self-insurance and any coverage measured against what claims may have been or may be asserted against the debtor that would be subject to insurance coverage. Too often, because of the press for time and the need for a prompt bankruptcy filing, debtors' attorneys fail to complete this very important inquiry before committing to the bankruptcy process. This is particularly true for claims that have not yet been subject to litigation, as the plaintiff may be required to file a proof of claim (because of the automatic stay) before commencing any litigation When contemplating a bankruptcy filing where these issues may be present, it is important to consult with the carrier's counsel before filing the bankruptcy proceeding to maximize strategic benefits to the insured.

All of the above demonstrates that what at first blush may appear to be a simple issue of insurance or bankruptcy law, may instead be a significant trap for the unwary.

David A. Grossbaum chairs the Insurance Services group at Hinshaw & Culbertson LLP. Practicing out of the firm's Boston and Providence, RI, offices, he handles insurance coverage matters throughout the country and defends professionals in liability cases. Charles M. Tatelbaum is a partner in the Bankruptcy & Creditors' Rights group and practices in the firm's Fort Lauderdale, FL, office. Matthew R. Watson is an attorney in the Insurance Services group and practices in the firm's Boston and Providence offices.