INSURANCE POLICIES. by Bankruptcy Code Section 541. That section provides, in pertinent part:

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2 BANKING LAW JOURNAL by Bankruptcy Code Section 541. That section provides, in pertinent part: The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held: (1) all legal or equitable interests of the debtor in property as of the commencement of the case. (6) Proceeds, products, offspring, rents, or profits of or from property of the estate. By choosing the phrase all legal or equitable interests of the debtor in property, Congress intended to include a broad range of property within the estate. 1 In essence, all economic rights the debtor holds at the commencement of the bankruptcy become property of the estate under Section 541. Property of the estate, however, is not limitless. The term generally is measured by the interests held by the debtor as of, or up to, the commencement of the case. As stated by the U.S. Court of Appeals for the Fifth Circuit, the estate s legal and equitable interests in property rise no higher than those of the debtor. 2 The estate includes only property to which the debtor would have a right if the debtor were solvent. 3 INSURANCE POLICIES The prevailing view is that an insurance policy is property of the estate pursuant to Section 541(a)(1). Numerous courts addressing whether property of the estate includes insurance policies have held that an insurance policy owned by the debtor is property of the estate under Bankruptcy Code Section The Fifth Circuit, speaking on the issue, stated [i]nsurance policies are property of the estate because, regardless of who the insured is, the debtor retains certain contract rights under the policy itself. 5 Continuing, the Fifth Circuit stated, [a]ny rights the debtor has against the insurer, whether contractual or otherwise, become property of the estate

3 INSURANCE PROCEEDS IN BANKRUPTCY The Fourth Circuit, in In re A.H. Robins Co., Inc., 7 made the same observation, stating that under the weight of authority, insurance contracts have been said to be embraced in this statutory definition of property. The insurance policy at issue in A.H. Robins was a products liability policy that insured the debtor against claims by consumers. The Ninth Circuit adopted the reasoning in A.H. Robins and applied it to an insurance policy that insured the debtor against claims by officers and directors. 8 The circuit court stated that the insurance policies met the fundamental test of whether they were property of the estate because the debtor s estate was worth more with them than without them. INSURANCE PROCEEDS Although the rights held by a debtor under insurance policies may be property of the estate, whether the funds paid by insurers on account of the insurance polices are property of a bankruptcy estate is an entirely different question. 9 A split of authority has developed regarding whether proceeds payable from such insurance are property of the estate. 10 Specifically, where a debtor owns the policies but has no interest in the proceeds, courts have held that the proceeds are not property of the estate. 11 As the Fifth Circuit explained in Edgeworth, the overriding question when determining whether insurance proceeds are property of the estate was whether the debtor would have a right to receive and keep those proceeds when the insurer paid on a claim. When payment by the insurer could not inure to the debtor s pecuniary benefit, then that payment should neither enhance nor decrease the bankruptcy estate. In other words, when the debtor has no legally cognizable claim to the insurance proceeds, those proceeds are not property of the estate. 12 Thus, under the Edgeworth analysis, the type of insurance at issue is critical for determining whether insurance policy proceeds are included within the estate of the insured/debtor. In the liability insurance context, a court recently observed 13 that a debtor had no cognizable claim to the proceeds paid by an insurer on account of a covered claim. Rather, the proceeds were paid to the victim of the insured s wrongful act. As the court noted, the insured debtor could not 701

4 BANKING LAW JOURNAL ask the insurance company to pay it, or determine on its own how the proceeds of the policy should be distributed, nor could any creditor of the insured seize the proceeds in satisfaction of a claim not falling within the terms of the insurance contract. In other words, the court explained, by purchasing ordinary liability insurance coverage (exclusive of indemnity coverage), an insured paid a premium in return for the promise by the insurer to defend the insured in an action, and pay, on the insured s behalf, the amount of any claim covered by the terms and conditions of the policy. However, the payment of a premium did not grant the insured a legal or equitable right to the funds used by the insurer to pay covered claims. Therefore, the court concluded, a bankruptcy trustee could not garner a right to the proceeds of a liability policy by means of the trustee s strong arm powers because the hypothetical ideal lien creditor (whose claim would not be covered by the insurance) could get no rights in, to or upon the proceeds by execution on the ideal lien. LOUISIANA WORLD Courts have held that if a debtor does not have a direct interest in the proceeds of the insurance policy, the insurance proceeds are no longer property of the debtor s estate. In In re Louisiana World Exposition, Inc., 14 a creditors committee sued various directors and officers of Louisiana World Exposition, Inc., for malfeasance and mismanagement. The creditors committee also sued the insurer on behalf of the estate. The creditors committee sought an injunction against the insurer and enforcement of the automatic stay to prohibit payments of the directors and officers legal expenses. The policy at issue included director and officer liability and corporate reimbursement coverage with a single liability limit of $20 million. The creditors committee argued that if it won its suit against the directors and officers, then it became entitled to the liability proceeds, which would have been diminished due to the directors and officers legal expenses if they obtained payments from the insurer. The Fifth Circuit distinguished between ownership of the policy and ownership of the proceeds. The Fifth Circuit ruled that the proceeds of the liability coverage afforded the Louisiana World Exposition directors and offi- 702

5 INSURANCE PROCEEDS IN BANKRUPTCY cers were not property of the Louisiana World Exposition bankruptcy estate. The court noted that the insurance claim at issue was the directors and officers liability coverage, not the indemnification coverage, and said the policy proceeds belonged to the directors and officers. The fact that [Louisiana World Exposition] purchased the policies does not change the outcome. The question is not who owns the policies, but who owns the liability proceeds. Although the answer to the first question quite often supplies the answer to the second, this is not always so. Even though Louisiana World Exposition purchased the insurance policy, the policy was for the benefit of the directors and officers, the court pointed out. The Fifth Circuit clarified when insurance proceeds are property of the debtor s estate in In re Edgeworth. 15 In Edgeworth, after a debtor physician was granted a chapter 7 discharge, relatives of a former patient sought approval to file a medical malpractice suit in state court. The court held that although the debtor s liability policy was a part of the debtor s estate, the proceeds of that policy were not. In reaching this conclusion, the court stated that the overriding question when determining whether insurance proceeds were property of the estate was whether the debtor would have a right to receive and keep those proceeds when the insurer paid on a claim. The court said that when the debtor had no legally cognizable claim to the insurance proceeds, those proceeds were not property of the estate. In this case, as in Louisiana World Exposition, the debtor had neither a direct interest in, nor a right to receive and keep, the insurance proceeds, the court concluded. Some courts have distinguished Louisiana World Exposition and have found insurance proceeds to be property of the debtor s estate. In In re Sacred Heart Hospital of Norristown, 16 the court found that because the directors and officers insurance policy provided liability coverage to the debtor itself, the proceeds were property of the debtor s estate. The court stated, proceeds available for the debtor s liability exposure are not segregated from the proceeds available to the directors and officers. Thus, the debtor is indeed an insured and has a sufficient interest in the proceeds as a whole to bring them into the estate. 17 The court in Sacred Heart thus distinguished Louisiana World Exposition based on the liability coverage provided to the debtor. Another court distinguished Louisiana World Exposition based on its focus on liability rather than indemnification coverage. In In re Circle K 703

6 BANKING LAW JOURNAL Corp., 18 the debtor requested a preliminary injunction against continued litigation of securities fraud actions against the debtor, its officers and directors. The court found that the debtor s insurance polices, which provided liability coverage for the debtor s officers and indemnification coverage for the debtor, were property of the debtor s estate. The court reasoned that the insurance policies, which covered reimbursement to the debtor of the officers litigation expenses, would become depleted through the ongoing litigation and the debtor s exposure in other litigation would increase as the policy limits were exhausted. The court stated, however, that plaintiffs in the securities fraud actions would not be permanently deprived of their right to seek redress and that litigation could proceed. In Circle K, the debtor had a claim to reimbursement under the policy for amounts paid as indemnification to the directors and officers. There was no such claim for reimbursement in Louisiana World Exposition. The court in In re The Leslie Fay Companies, Inc. 19 also distinguished Louisiana World Exposition. In Leslie Fay, the shareholders brought a class action lawsuit against the directors and officers and there was also a stockholder derivative action pending against the directors and officers. The directors and officers tried to settle the class action lawsuit using part of the proceeds from their directors and officers single-limit policy. The court held that as long as there was a pending derivative action, the debtor would have an interest in any insurance proceeds available as a result of its officers or directors wrongful acts. The reason the debtor had an interest in the proceeds was because of the possibility that the class action might deplete the policy and theoretically force claims for indemnification to fall upon the estate. The court, however, also found that the intended beneficiaries of the policy are both the individuals and the corporation, and not solely the corporation. As such, the directors and officers could still claim a substantial portion of the insurance proceeds, it concluded. D&O INSURANCE A recent decision by an Ohio bankruptcy court illustrates how the dispute over insurance policies and proceeds can arise in practice, and how a 704

7 INSURANCE PROCEEDS IN BANKRUPTCY bankruptcy court might resolve the issue today. 20 The case arose after the Youngstown Osteopathic Hospital Association (YOH) entered chapter 11 and filed an adversary complaint against former officers and directors, members of the Board of Trustees, and management of YOH. The complaint alleged breaches of fiduciary duties, negligence, negligent hiring, supervision and retention, fraud, fraudulent transfers, misappropriation, conspiracy and misrepresentation. YOH also filed a motion seeking enforcement of the automatic stay under Bankruptcy Code Section 362 against the Ohio Hospital Insurance Company (OHIC), which had issued directors and officers liability insurance to YOH. YOH did not want OHIC to make any payments under the policy to the defendants in the adversary proceeding. The named insured on the D&O policy was YOH, and it was a claims made policy. The total amount of coverage available under the D&O policy was $5 million. The policy stated in part: 1. Insurance Clause: The Company named on the Declarations page (a stock insurance corporation, herein called the Insurer) in consideration of the payment of the premium and subject to all of the terms, conditioned and limitations of this policy, agrees as follows: (a) With the Directors, Officers and Trustees of the Named Insured that if during the policy period any claim or claims are first made against the Directors, Officers and Trustees, individually or collectively, for a Wrongful Act, the Insurer will pay, in accordance with the terms of this policy, on behalf of the Directors, Officers and Trustees, all loss of which the said Directors, Officers and Trustee shall become legally obligated to pay. (b) With the Named Insured that if during the policy period any claim or claims are made against the Directors, Officers and Trustees, individually or collectively, for a Wrongful Act, the Insurer will pay, in accordance with the terms of this policy, on behalf of the Named Insured all loos for which the Named Insured may be required or permitted by law to indemnify such Directors, Officers and Trustees. 705

8 BANKING LAW JOURNAL In its opinion on YOH s motion to enjoin OHIC from making any payments under the D&O policy to the defendants, the court noted that D&O policies are obtained for the protection of individual directors and officers. The court added that there was an important distinction between the individual liability and the reimbursement portions of a D&O policy. In the court s view, the liability portion of a policy provides coverage directly to officers and directors, insuring the individuals from personal loss for claims that are not indemnified by the corporation. Unlike an ordinary liability insurance policy, in which a corporate purchase obtains primary protection from lawsuits, a corporation does not enjoy direct coverage under a D&O policy. Rather, the court continued, it is insured indirectly for its indemnification obligations. In essence and at its core, a D&O policy remains a safeguard of officer and director interests and not a vehicle for corporate protection. With these thoughts, and the actual language of YOH s insurance policy in mind, the court concluded that the proceeds of the D&O policy at issue were not property of YOH s estate. The court emphasized that the contractual provisions within YOH s insurance policy included director and officer liability coverage and indemnity coverage, but that there was no entity coverage that would cover the corporation s own losses. Although YOH was the named insured on the policy, the court said, the policy was for the benefit of the directors and officers. YOH owned the policy, but it did not own the proceeds at issue. Noting that the defendants had made a claim under the D&O policy, the court concluded that they were entitled to the proceeds. The court added that YOH s argument that it had a pecuniary interest in the D&O policy was without merit because there had been no claim made against the indemnity coverage. YOH had not paid any of the defendants defense costs, and so it was not entitled to be reimbursed, the court said. Moreover, it continued, YOH did not have entity coverage with OHIC, which would have directly insured YOH. The court concluded by observing that this case essentially was indistinguishable from Louisiana World Exposition, with the only difference between the two cases being that the named insureds in Louisiana World Exposition were the directors and officers themselves, whereas in this case, 706

9 INSURANCE PROCEEDS IN BANKRUPTCY YOH was the named insured. In the court s view, this difference was irrelevant because the D&O policy was for the benefit of the directors and officers, regardless of whom the named insured may be. Accordingly, the court concluded that YOH s insurance policy in general was property of YOH s estate, but that the D&O policy proceeds were not. CONCLUSION Creditors should carefully review insurance policies issued to debtors that have entered bankruptcy. They may discover an asset that can help make them whole. NOTES 1 See United States v. Whiting Pools, Inc., 462 U.S. 198 (1983). 2 In re Louisiana World Exposition, Inc., 832 F.2d 1391, 1399 (5th Cir. 1987) (quoting In re Gagnon, 26 B.R. 926, 928 (Bankr. M.D. Pa. 1983). 3 See, e.g., First Fidelity Bank v. McAteer, 985 F.2d 114 (3d Cir. 1993). 4 See, e.g., In re Vitek, Inc., 51 F.3d 530, 533 (5th Cir. 1995); In re Edgeworth, 993 F.2d 51, 55 (5th Cir. 1993); In re A.H. Robins Co., Inc., 788 F.2d 994, 1001 (4th Cir. 1986); In re Davis, 730 F.2d 176, 184 (5th Cir. 1984); In re Johns-Manville Corp., 40 B.R. 219, (S.D.N.Y. 1984). 5 Edgeworth, 993 F.2d at Id F.2d 994, 1001 (4th Cir. 1986). 8 In re The Minoco Group of Cos., Ltd., 799 F.2d 517, 519 (9th Cir. 1986). 9 See, e.g., In re Goodenow, 157 B.R. 724 (Bankr. D. Me. 1993) (citing cases). 10 Compare, e.g., Edgeworth, supra; McAteer, supra; Louisiana World Exposition, supra; and In re Daisy Sys. Sec. Litig., 132 B.R. 752 (N.D. Cal. 1991), cases that hold that proceeds of insurance policies in certain contexts are not property of the estate, with Vitek, supra; Tringali v. Hathaway Mach. Co., Inc., 796 F.2d 553 (1st Cir. 1986) ( language, authority, and reason all indicate that proceeds of a liability insurance policy are property of the estate ); In re Forty-Eight Insulations, Inc., 54 B.R. 905 (Bankr. N.D. Ill. 1985) ( insurance policies and their proceeds are property of the estate ); and In re Johns-Manville Corp., 26 B.R. 420 (Bankr. S.D.N.Y. 1983) ( The 707

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