Insurance Litigation and Bankruptcy, or How to Escape from Wonderland

In the tale of “Alice in Wonderland,” little Alice heedlessly follows the white rabbit into the rabbit hole and falls ever so long before landing upon a heap of sticks and dry leaves. Jumping up and looking around, she finds:

There were doors all around the hall, but they were all locked; and when Alice had been all the way down one side and up the other, trying every door, she walked sadly down the middle, wondering how she was ever to get out again.

“Alice’s Adventures in Wonderland,” Lewis Carroll.

When an insurance carrier, or an insurance carrier’s attorney, finds himself litigating in bankruptcy court over coverage issues, it often feels much like Alice felt when she found herself lost in Wonderland with no clear way out. Litigating insurance issues in the bankruptcy court complicates matters for both the debtor/insured as well as the carrier. And while the following includes some basics regarding litigation in bankruptcy court, the first rule is that you should not hesitate to employ bankruptcy professionals who have insurance experience. See “Insurance and Bankruptcy,” Michael Sean Quinn and Brian S. Martin, 36 Tort & Insurance Law Journal, p. 1025 (Vol. 36, Number 4, Summer 2001).

Most insurance litigation that proceeds in the bankruptcy context is in the form of an adversary proceeding. Sometimes, when the insured is also the debtor and has sued the insurer in a declaratory judgment action, the automatic stay does not apply, so the litigation is outside of the context of bankruptcy even though the insured is a bankrupt debtor. On other occasions, litigation between the insured and an insurer can go forward as an adversary proceeding in the bankruptcy court.

A good illustration of this occurs when the bankruptcy court takes over a declaratory judgment action on the issue of coverage. Such actions can be removed from state courts. In Re: Pierce Mortuary Colleges Inc., 212 BR 549 (Bankruptcy N.D. TX 1997). In Pierce Mortuary Colleges Inc., the debtors owned and operated training schools for morticians. They wrongfully obtained dead bodies and used them to instruct their students on how to embalm the departed. The relatives of the deceased did not know about, and of course did not consent to, these activities. When the activities became public, lawsuits were filed. Eventually, the debtor’s mortuary schools declared bankruptcy.

The principal issue in the case is whether there had been an accident, which is necessary for coverage in standard general liability policies. The bankruptcy judge held that there had been no accident because the actions of the debtors were intentional and the consequences reasonably foreseeable.

The following examples illustrate how these issues fit together. If a policyholder sues an insurer for breach of the insurance contact, that would probably be a core adversary action. A “core” proceeding is one “arising under” the Bankruptcy Code or “arising in” a bankruptcy case. “Noncore” proceedings are “related to” proceedings including those that have no connection to the bankruptcy case. In essence, a “core” proceeding is central to the bankruptcy and the court will most likely retain jurisdiction over a “core” proceeding. If an insurer makes a claim in bankruptcy for unpaid premiums, that would probably not be an adversary action, but would simply be a claim like that of any other creditor.

Bankruptcy procedure has more than a little bearing on how insurance cases are litigated. The coverage action can be proceeding peaceably in state court, when all of a sudden it will be removed to federal district court in some remote jurisdiction. That court may or may not send the case back. If it is a “related to” proceeding, the parties may or may not consent to have it tried before the bankruptcy court.

When litigating in bankruptcy court there are strategy considerations. For instance, where there is an option to proceed with the insurance dispute in bankruptcy court or to seek adjudication in the state court; there are several practical considerations. An initial consideration is that bankruptcy courts are usually well versed in commercial litigation and particularly in contract construction—the very heart of most insurance disputes. In contrast, state courts, with few exceptions, are usually more familiar with tort issues than complex contract issues.

A second consideration is that bankruptcy procedure and practices will frequently have some impact not only on how insurance cases are litigated, but also on potential results. For instance, if the matter proceeds in bankruptcy court, it would be controlled by the rulings of the district or controlling appellate court decisions interpreting the relevant state’s laws. Thus, where the state’s law is unsettled or there are conflicting precedents among state courts, but there is relatively settled law in the federal court interpreting that state’s law, the choice of proceeding in the bankruptcy court may potentially decide the issue.

An actual example is the application of the trigger of coverage in property damage cases in Texas. The Texas Supreme Court has not ruled with finality on the applicable trigger, and there is some conflicting law among the various intermediate state court appellate decisions as to whether the proper trigger for property damage claims is a manifestation or exposure trigger. However, the Fifth Circuit has consistently adopted the manifestation trigger as the controlling Texas law in connection with property damage cases. Thus, while a Texas trial court or intermediate appellate court may decide to depart from the manifestation rule, the bankruptcy court sitting in Texas has no latitude in deciding whether to follow the Fifth Circuit precedent.

A third consideration is that proceeding in bankruptcy court on the coverage issues means that the insurer may have two appeals, with the first to the federal district court. In many state courts, a party may appeal as a right to the intermediate court and have a small possibility of the state’s highest court accepting an appeal. In bankruptcy court, however, the appeal from the bankruptcy court to the federal district court is de novo, with an appeal from the district court, by right, to the court of appeals. Obviously, it is extremely unlikely that the U.S. Supreme Court offers an appellate option as to most issues that are matters of state law and the high court accepts far too few cases to make it a viable option. Even so, the appellate options available in the federal court system, especially starting from the bankruptcy court, are usually broader than those available in the state court system.

A fourth consideration of whether to proceed in bankruptcy court is the applicability of the federal summary judgment standard, which is broader than that in many states. On the other hand, another procedural advantage, or disadvantage, may be the lesser likelihood of having a jury trial and the dispatch with which bankruptcy courts often move in handling even complex litigation. In these circumstances, the bankruptcy court is likely to proceed to trial, especially where it is a bench trial, much more swiftly than a state court.

Finally, there is usually less bias against insurance companies or other corporations in the bankruptcy court than is frequently found in state courts or with state court juries. Indeed, the very reason for diversity jurisdiction is to avoid local bias that often translates into prejudice against foreign corporations. The federal court is often seen as a refuge from such biases. Insurance companies may consider the option of litigating their coverage disputes involving a debtor in the bankruptcy court where diversity jurisdiction would not otherwise be available.

In addition to these litigation considerations, there are many issues of substantive law, which may impact the handling of your insurance claim. For instance, the insurance policy and its proceeds are often property of the estate if the insured debtor is the owner and beneficiary of a nonexempt insurance policy. See Matter of Edgeworth, 993 F.2d 51 (5th Cir. 1993). Coming full circle, the insurance professional faced with bankruptcy should consider not only the forum and procedural issues, but recognize the many substantive issues raised by the bankruptcy filing.

If this is done early on and the bankruptcy considerations are carefully evaluated, then at some point, maybe way off in the distant future, you will hear a voice, just as Alice did, saying, “Wake up, Alice dear! Why, what a long sleep you’ve had!” To which Alice replied, “Oh, I’ve had such a curious dream!” Similar to Alice, you will have successfully emerged from the rabbit hole intact and with a story to tell.

Brian S. Martin is a partner in the Insurance and Coverage Section of the Houston office of Thompson, Coe, Cousins & Irons, L.L.P. He has extensive experience in insurance coverage and defense matters, specializing in environmental, toxic tort and products cases. Martin in a frequent author and CLE speaker on insurance topics, including coverage and bad faith issues.