United States: Appellate Court Vindicates Insurers Position That Coverage Dispute Is Not A Core Bankruptcy Matter

In a published decision issued on August 25, 2016, the Bankruptcy Appellate Panel for the Ninth Circuit ("BAP") vindicated the position of Troutman Sanders' insurance company clients that a post-petition insurance dispute over the meaning of a pre-petition liability insurance policy's prior consent condition is not a core bankruptcy proceeding over which the bankruptcy court is authorized to issue final determinations without all parties' consent. As the bankruptcy court erroneously relied on the opposite conclusion in denying the insurers' motion for mandatory or permissive abstention in light of a pending suit the insured filed first in state court, the BAP vacated the order denying the insurers' motion and remanded for further proceedings. Troutman Sanders represented Certain Underwriters at Lloyds. A copy of the opinion can be viewed here.

GACN, Inc. has a liability insurance policy under which it has been receiving a defense against wrongful termination litigation brought by certain former GACN employees. Pre-trial settlements were reached with some of them and the rest proceeded to trial. A judgment was rendered against GACN and a timely notice of appeal was filed. GACN then filed a voluntary Chapter 11 bankruptcy petition and, somewhat later, sued its insurers and its defense counsel in Los Angeles Superior Court in connection with the wrongful termination litigation, alleging among other things breach of contract and bad faith. Meanwhile, GACN unilaterally negotiated and entered into a fully-executed written settlement agreement with the underlying claimants.

In response to GACN's state court lawsuit, the insurers pled as one of their affirmative defenses the fact that the insured unilaterally entered into a settlement agreement with the underlying claimants without complying with the policy's prior consent condition. The insured then initiated an adversary proceeding in the bankruptcy court seeking declarations concerning the prior consent condition's meaning, and asked the state court for a stay in deference to GACN's adversary proceeding. Contending that it was, instead, the bankruptcy court that should defer to the first and more comprehensive state court action under the circumstances, the insurers filed a motion for mandatory abstention or, in the alternative, for permissive abstention.

The bankruptcy court denied the motion based on its conclusions that: (1) the underlying insurance dispute is a core bankruptcy matter; (2) it is not a purely state law matter; and (3) it cannot be timely adjudicated in state court, reasoning the bankruptcy court can decide the matter faster than the state court. Each conclusion negated a factor required for mandatory abstention. Further, the bankruptcy court declined to grant the insurers' motion for permissive abstention.

On appeal, the BAP held that the bankruptcy court erred in concluding that the underlying insurance dispute is a core bankruptcy proceeding. The BAP began with the general rule adopted by the Ninth Circuit in In re Castlerock Props., 781 F.2d 159, 162 (9th Cir. 1986): "state law contract claims that do not specifically fall within the categories of core proceedings enumerated in 28 U.S.C. § 157(b)(2)(B)-(N) are [noncore] proceedings ... even if they arguably fit within the literal wording of the two catch-all provisions, sections 157(b)(2)(A) and (O)." Examining in detail three subsequent Ninth Circuit cases, the BAP concluded: "When we look at the ... cases as a whole, we are persuaded that GACN's declaratory relief action against the insurer is not a core proceeding. The underlying dispute solely concerns the parties' rights and liabilities under a prepetition insurance contract, which was entered into pursuant to state law rather than as a part of a bankruptcy case. Additionally, the insurer has not attempted to assert against GACN any sort of affirmative claim for relief challenging any aspect of GACN's performance of its statutory duties as a debtor in possession or otherwise implicating core bankruptcy claims procedures. We recognize and appreciate the major impact the declaratory relief action is having and will continue to have on GACN's bankruptcy case. ... The facts of this case simply do not satisfy the Ninth Circuit's strict standards for core jurisdiction."

The BAP held that the bankruptcy court also erred in concluding that the underlying dispute raised both state law questions and bankruptcy law questions, explaining: "On its face, GACN's complaint only asks for a determination of the parties' rights and liabilities under the insurance contract, which is wholly governed by state law. The bankruptcy court posited that bankruptcy law questions might arise because the action will affect GACN's rights and duties as a debtor in possession and also might impair GACN's ability to obtain bankruptcy court approval under Rule 9019 of its settlement with the wrongful termination plaintiffs. The bankruptcy court's reasoning conflates the potential impact of the action with the law governing the action."

The BAP then reasoned that, "because the bankruptcy court erroneously concluded that the dispute was a core proceeding, the bankruptcy court's timeliness calculation necessarily was off. When, as here, the dispute is a noncore proceeding, and one of the parties has not consented to the bankruptcy court entering a final decision ..., the bankruptcy court cannot itself enter a final decision, but rather must submit proposed findings of fact and conclusions of law to the district court, which can only enter a final decision after considering the bankruptcy court's proposed findings and conclusions and after reviewing de novo any matter a party has timely and specifically objected to. ... When the ... district court review process is factored into the timeliness equation, the bankruptcy court might conclude that GACN could obtain a more timely resolution of the issues underlying the declaratory relief action by seeking from the state court summary adjudication of the insurer's ... affirmative defense in the state court action." Therefore, the BAP vacated the bankruptcy court's ruling and remanded with instructions to resolve the mandatory abstention request based solely on the resolution of the timeliness issue.

The BAP not only vacated the bankruptcy court's ruling on the mandatory abstention motion but vacated the bankruptcy court's ruling on the permissive abstention motion as well. This is because the "errors regarding the presence of a core proceeding and regarding the predominance of bankruptcy law issues over state law issues infected the bankruptcy court's discretionary abstention analysis." And the BAP concluded "the errors were not harmless" because several of the discretionary abstention factors "might be weighed differently if the noncore status of the action and the predominance of state law issues are accounted for[.]"

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Ross Smith
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