United States: Third Circuit Reaffirms That Section 1123(A) Of The Bankruptcy Code Preempts Insurance Policies’ Anti-Assignment Provisions

Last Updated: October 21 2013
Article by Brian P. Morgan

Over the last two decades, many companies faced with excessive asbestos-related liabilities have successfully emerged from bankruptcy with the help of section 524(g) of the Bankruptcy Code, which channels all asbestos-related liabilities of the reorganized company to a newly formed personal injury trust. The injunctive relief codified in section 524(g) is modeled on the channeling injunction first crafted in the bankruptcy case of Johns-Manville Corporation, once the world's largest producer of asbestos-containing products. In that case, the bankruptcy court issued a channeling injunction under section 105 of the Bankruptcy Code that required claimants to seek redress from a trust established to compensate victims of asbestos exposure and that prohibited any future actions against the reorganized company, its subsidiaries or the settling insurers. See In re Johns-Manville Corp., 68 B.R. 618, 624-28 (Bankr. S.D.N.Y. 1986), aff 'd, 78 B.R. 407 (S.D.N.Y. 1987), aff 'd sub nom, Kane v. Johns-Manville Corp., 834 F.2d 636 (2d Dir.).

Recognizing that the channeling injunction employed in Johns-Manville was a "creative solution to help protect ... future asbestos claimants," H.R. Rep. No. 103-835 at 47 (1994), while simultaneously allowing the debtor to obtain the "fresh start" promised by bankruptcy, and wishing to remove any doubts as to its validity, Congress codified the injunction at section 524(g) of the Bankruptcy Code. 4 Collier on Bankruptcy (16th Ed.) ¶ 524.07. The bankruptcy court may issue a channeling injunction under section 524(g) only if certain statutory prerequisites are met, including the approval of seventy-five percent (75%) of current claimants. 11 U.S.C. § 524(g)(2)(B). Once an injunction is entered, the trust assumes all liability for paying current and future asbestos claims and demands from its income and assets. Asbestos trusts are generally funded from a combination of the debtor's cash, stock and interests in insurance policies covering the debtor's asbestos-related liabilities. In re Federal-Mogul Global, Inc., 684 F.3d 355, 360 (3d Cir. 2012). Such insurance policies typically contain, however, anti-assignment provisions that bar an insured from transferring the policies or their rights under the policies without the insurer's consent. Id. at 363. In many bankruptcy cases involving asbestos claims, insurers have consented to the assignment of a debtor's insurance policy proceeds as part of a settlement of insurance rights in exchange the protections of a section 524(g) channeling injunction. Absent consent, however, insurers have objected on the basis that the proposed assignment contemplated by a plan of reorganization violates a policy's anti-assignment provision. Such was the case in the bankruptcy of Federal-Mogul Global, Inc.

Federal-Mogul, a manufacturer of automobile parts, and over 150 of its affiliates filed chapter 11 bankruptcy petitions in the District of Delaware in October 2001. 684 F.3d at 363. The company estimated that it had spent approximately $350 million in the year prior to its bankruptcy filing defending and indemnifying asbestos claims. Id. Approximately 500,000 asbestos claims remained pending as of the petition date. Id. The bankruptcy proceedings lasted more than six years until a plan of reorganization was finally confirmed in late 2007. The plan provided for the creation of a post-confirmation trust under section 524(g), from which all present and future asbestos-related claims were to be paid. Id. The plan assigned various assets to the trust, including Federal-Mogul's right to collect proceeds from certain liability insurance policies. Id.

Several insurers objected to the plan on the ground that the assignment of rights to the insurance policies in question was prohibited by the policies' anti-assignment provisions. Id. Federal-Mogul countered that the anti-assignment provisions were preempted by section 1123(a)(5)(B) of the Bankruptcy Code, which provides that a chapter 11 plan of reorganization shall provide adequate means for its implementation, including the potential transfer of property of the estate, "[n]otwithstanding any otherwise applicable nonbankruptcy law." 11 U.S.C. § 1123(a)(5)(B). So as not to delay consummation of the plan, Federal-Mogul and the insurers agreed to carve out the preemption issue from the confirmation order, reserving the right to appeal the bankruptcy's court decision with respect to preemption. 684 F.3d at 363.

The bankruptcy court and the district court agreed with Federal Mogul, reasoning that the assignment was permitted by section 541(c) of the Bankruptcy Code, which provides that "an interest of the debtor in property becomes property of the estate ... notwithstanding any provision in a transfer agreement, transfer instrument, or applicable nonbankruptcy law," while the section 1123(a)(5) allowed transfer to the trust. In re Federal-Mogul Global, Inc., 385 B.R. 560, 556-67 (Bankr. D. Del. 2008); In re Federal-Mogul Global, Inc., 402 B.R. 625, 630-38 (D. Del. 2009).

In affirming the lower courts, the Third Circuit Court of Appeals first rejected the insurers' contention that the issue was one of first impression. The Court noted that the same question was decided in favor of preemption in In re Combustion Engineering, Inc., 391 F.3d 190 (3d Cir. 2004), but conceded that it "was not one of the paramount issues on appeal." 684 F.3d at 365. Thus, the Court concluded that a "thorough preemption analysis," including a discussion of the statutory language, structure and legislative history of section 1123, was warranted. Id. at 367.

The Court found that the plain language of section 1123, including the "critical words" "... [n]othwithstanding any otherwise applicable nonbankruptcy law," evidenced Congress's clear intent to preempt state law. Id. at 369. The Court further held that "otherwise applicable nonbankruptcy law" encompasses private contracts like the insurance policies at issue, despite the lack of any reference to contractual agreements, because many of the transactions listed under section 1123(a)(5) implicate contractual rights. Id. at 370.

The insurers advanced a number of arguments in favor of a narrow reading of section 1123(a), each of which was rejected in turn by the Third Circuit. The Court dismissed the insurers' structural argument that the applicability of the "notwithstanding" clause in the preamble of section 1123(a) is limited to the eight numbered subsections and does not extend to the transactions enumerated under section 1123(a)(5) and concluded that such an interpretation would lead to "absurd results" because many of the listed transactions could not be accomplished in the absence of preemption. Id. With respect to the insurers' contention that the pre-Code bankruptcy history and legislative history weighed against a finding that section 1123(a) does not preempt state law, the Court held that "the evidence from these sources is too equivocal to overcome the plain meaning of the text, which provides compelling evidence of Congress's intent to preempt contrary non-bankruptcy law." Id. at 374.

The Court noted that preemption of anti-assignment provisions in insurance policies furthers the purposes of the Bankruptcy Code. Id. at 378. Federal-Mogul sought to use its existing assets, including its rights under the insurance policies, to address current and future asbestos claims arising out of past occurrences while resolving its asbestos-related liability—"a goal consonant with the 'fresh start' promised by bankruptcy." Id. The Court also noted that preemption furthers Congress's intent in enacting section 524(g), which is to maximize the amount of assets available to pay asbestos claimants while allowing the reorganized debtor to remain viable. Id. If the anti-assignment provisions were not preempted, the Court reasoned, the objectives of the Bankruptcy Code and Congress would be frustrated by the debtor's and claimants' loss of access to assets specifically intended to compensate those suffering from asbestos-related diseases. Id. at 379.

Lastly, the Court addressed the insurers' argument that the assignment increased their exposure and bargained-for coverage risk. Id. Because the asbestos-related liabilities transferred from Federal-Mogul to the trust were "based on events which had already occurred and for which the insurers were already potentially responsible," the Court questioned whether the insurers' risk increased in a meaningful way. Id. The Court conceded that asbestos claims would subsequently be adjudicated by the trust's distributions protocols, as opposed to the state law tort system, but noted that such procedures are mandated by Congress and must be approved by the bankruptcy court. Id. at 379-80 (citing 11 U.S.C. § 524(g)(2)(B)(ii)(V)).

In concluding that Federal-Mogul's insurers' liability was not increased by virtue of the assignment, the Court was careful to note that other factual circumstances may compel a different outcome. Id. at 380. For example, in In re Global Industrial Technologies, Inc., 645 F.3d 201 (3d Cir. 2011), the Third Circuit held that insurers' risk was significantly altered where the plan's creation of a silica trust expanded the number of silica-related claims to 4,600 from 169. 645 F.3d at 213-14. There was also substantial evidence in Global Industrial of collusion between the debtor and claimants' counsel. Id. at 214.

While the record evidence in Federal-Mogul Global did not rise to the level of the "exceptional and well-documented increase in risk" established in Global Industrial, the Court suggested that such a finding may preclude the transfer of insurance rights. 684 F.3d at 379-80. However, in the absence of evidence demonstrating a significant increase in exposure or possible collusion, the question of whether a reorganizing debtor facing massive asbestos-related liabilities will be allowed to assign insurance assets to fund a trust established pursuant to section 524(g) appears settled in the Third Circuit.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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