Litigation practitioners are often introduced to the US Bankruptcy Code when they face the automatic stay of Title 11 of the United States Code Section 362 (11 U.S.C. § 362) in a case they are pursuing on behalf of plaintiffs trying to prove up and quantify damages caused by the debtor.
Most lawyers facing the filing of a bankruptcy case know that pre-bankruptcy creditors may not enforce claims against a bankruptcy debtor, or against property of the estate of a bankruptcy debtor, without first obtaining relief from the automatic stay from the Bankruptcy Court (11 U.S.C. § 362(d)). Although some few matters are excepted from the stay's reach, most plaintiffs find themselves seeking relief from the automatic stay under Section 362(d) for "cause," if they wish to continue litigation against the debtor in state or federal courts.
This principle is easy to apply in two-party litigation when a plaintiff is adverse to a defendant who files bankruptcy between the filing of the complaint and the conduct of the trial or entry of judgment. Only rarely in a simple two-party dispute is relief from stay granted to continue litigation outside of the bankruptcy case to determine the merits of the claims and quantify damages - in re Caves, 309 B.R. 76 (Bkrtcy. M.D.Ga. 2004) (relief denied). This is especially true if the claims asserted against the debtor do not require special expertise or involve substantial application of local law. The question normally comes down to how close to resolution the action is at the time the bankruptcy case is filed and the balance of harms that would flow from continuing litigation in the selected forum or proceeding in bankruptcy. If it is early in the non-bankruptcy litigation, relief from stay will be denied. If it is late in the litigation, and the trial court has invested significant time and effort in learning the facts and legal theories, relief from stay may be granted to wrap the case up and liquidate the creditor's claim. In SCO Group, Inc., 395 B.R. 852 (Bkrtcy. D.Del. 2007) (relief granted where state court action was pending for four years and bankruptcy was filed on eve of trial). The reason this is true is that bankruptcy courts are expert at liquidating creditor claims against bankruptcy estates in summary proceedings or "mini trials". Disputes that consume significant time and attorney's fees if liquidated in state or federal court litigation will be more efficiently resolved in an objection to claims proceeding in the bankruptcy case. Efficiency should be valued by both the debtor, whose resources are limited, and the creditor, who will be spared spending 100 cent-dollars to prove up and quantify a claim that will receive less – sometimes much less – than hundred-cent dollars in recovery.
The stay analysis becomes more complex when a bankruptcy debtor's directors and officers are defendants in litigation where the debtor may or may not be named, but where the conduct of one or more director and officer defendants may be covered by pre-bankruptcy insurance policies issued at the bankruptcy debtor's expense. May the plaintiff continue its litigation against non-debtor D&O defendants, despite the stay of continued litigation against the debtor defendant? May an insurer pay proceeds of the debtor's D&O policy to fund a defense of covered claims, even if payment of defense costs depletes the policy, the proceeds of which could be used to pay the very creditor claims being litigated if liability is found? May an insurer pay proceeds of the debtor's D&O policy when the debtor's bankruptcy estate representative is actually the plaintiff in an action against former directors or officers? Or, alternatively, is the insurer's payment of defense costs stayed because the plaintiff cannot deprive the bankruptcy estate of the benefits of the policy? If the litigation is stayed, should the insurer be granted relief from stay to continue funding the defense of the potentially covered claims?
Litigation against non-debtors may continue without violating the automatic stay. If the debtor must be joined as a nominal party to the litigation, relief from stay will ordinarily be granted provided no enforcement action is taken should the litigation be resolved adversely to the debtor. Law is not fully settled regarding the insurer's obligation to pay covered defense costs.
Bankruptcy, District and Circuit Courts of Appeal, directly or indirectly and expressly or implicitly, agree that a D&O policy itself is property of debtor's bankruptcy estate. However, in contrast to the D&O policy itself, the proceeds of the policy are generally not considered to be estate property unless the policy contains entity coverage for the debtor itself, or unless the debtor has actually made advances to the directors and officers of claims that it has indemnified and the indemnification advances may be reimbursed by coverage under the D&O Policy. In re Louisiana World Exposition, Inc., 832 F.2d 1391, 1401 (5th Cir. 1987)(LWE) (D&O policy constitutes estate property, but policy proceeds are not); in re Continental Airlines, 203 F.3d 203, 216 (3d Cir. 2000) (adopting LWE distinction in dicta); in re Pintlar Corp., 124 F.3d 1310, 1314 (declining to adopt LWE but reversing issuance of stay by bankruptcy court to protect dissipation of D&O policy through defense payments); in re Adelphia Communications Corp., 298 B.R. 49, 52-54 (S.D.N.Y. 2003); in re World Health Alternatives, Inc., 369 B.R. 805, 809 (Bkrtcy D.Del. 2007) (policy estate property, proceeds not where no entity coverage and no actual debtor indemnity payments); in re Youngstown Osteopathic Hospital Association, 271 B.R. 544, 548 (Bkrtcy. N.D. Ohio 2002) (policy estate property proceeds not where debtor had no direct interest).
An insurer should be granted relief from stay in a jurisdiction where there is no controlling precedent that makes clear the proceeds of the policy are not property of the estate. After all, the insurer should not be faced with a bad faith claim from the insureds because it has not covered defense costs due to the stay. In a jurisdiction where the law is clear, insurers will need no judicial intervention. In all others where the law is unsettled or the facts mixed, insurers will frequently be well advised to seek "comfort orders" granting relief from stay, to the extent applicable, and permitting payment of defense costs on an incremental basis. The insurer should present specific facts that the debtor has no entity coverage under the policy, has made no indemnity payments to the directors or officers that would be subject to reimbursement under the policy, or that some element of the debtor's conduct excludes coverage such that the debtor's estate cannot recover from the policy.
This article was first published in 'Global Insight', our e-newsletter which includes news, views and analysis from our Global Restructuring Group.
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