Claims covered by insurance dwell in the netherworld between bankruptcy and insurance. The recent case of Wolkowitz v. Redland Insurance Co., 5 Cal. Rptr. 3d 95 (2003), explores the limits of the extra-bankruptcy use of insurance to satisfy covered claims allowed in a bankruptcy case. Although Wolkowitz involved a single claim (albeit for more than $25 million), the same dynamics are often magnified in any type of mass tort bankruptcy case.

In Wolkowitz, a chapter 7 trustee for an insured corporate debtor brought an action in a California state court against its insurer for, inter alia, bad-faith failure to settle a pre-petition personal injury claim. The underlying claim arose from personal injuries that were allegedly caused by the debtor's defective installation of equipment in the claimant's motor vehicle. The insurer defended the claim pre-petition. The claimant offered to settle the claim for the policy limits; however, the insurer refused to accept the offer. The debtor subsequently filed a voluntary chapter 7 case before the scheduled trial date.

Almost immediately after the bankruptcy case was filed, the claimant sued the insurer in state court for abuse of process and intentional infliction of emotional distress, alleging that the attorneys hired by the insurer had induced the debtor to file bankruptcy in an effort to prevent the claimant from obtaining a state court judgment in excess of the policy limits. That suit was dismissed on the ground that the bankruptcy court had exclusive jurisdiction to determine whether the bankruptcy case was filed in bad faith.

During the bankruptcy case, the trustee and the claimant entered into a settlement agreement, subject to bankruptcy court approval, allowing the claim against the bankruptcy estate as a general unsecured claim in the amount of $26,225,000. The agreement further provided that the claimant would not seek any recovery against the debtor, but instead would look solely to any proceeds recovered from the insurer. The trustee and the claimant also agreed to split any proceeds that the trustee recovered from the insurer.

The trustee moved the bankruptcy court to approve the settlement agreement and allow the claim. The notice advised that any interested party could oppose the motion and request a hearing, and that failure to oppose the motion could be deemed as consent to the relief requested. The notice was served on the insurer. The motion was not opposed by the insurer or any other creditor, and accordingly, the bankruptcy court approved the settlement agreement and allowed the claim.

Following the bankruptcy court's allowance of the claim, the trustee filed a new action in California state court against the insurer and several other defendants alleging, inter alia, that the insurer breached the contract and the implied covenant of good faith and fair dealing. The trustee alleged that the bankruptcy court's allowance of the claim in the amount of $26,225,000 constituted a "final judgment" against the debtor, and that the insurer was liable to the bankruptcy estate in that amount. The trial court sustained demurrers without leave to amend and dismissed the complaint against all defendants with prejudice. The trustee appealed.

On appeal, the trustee contended that, because the debtor and the insurer received notice of the motion to approve the agreement with the claimant and to allow the claim, and could have objected but did not, the subsequent bankruptcy court order allowing the claim was a final judgment against the debtor for which the insurer is liable. The trustee also alleged that the debtor's inability to pay the claim did not relieve the insurer of liability for its alleged bad-faith refusal to settle.

The California appeals court affirmed the trial court's dismissal. It denied the trustee's claim that the bankruptcy court order allowing the claim as a final judgment of debtor's liability conclusively determines that issue. Relying on California law, the appeals court denied that the order allowing the claim constitutes a judicial determination that accurately reflects debtor's actual liability or provides a reliable basis to establish damages caused by the insurer's refusal to settle. The appeals court pointed out that the bankruptcy court did not determine the validity of the amount of the claim after a contested evidentiary hearing; rather, it simply granted the trustee's unopposed motion to allow the claim. The appeals court noted that the trustee not only failed to object to the claim, but in fact moved the bankruptcy court to allow it for the purpose of benefiting the estate by creating a basis for suing the insurer for bad faith. Although the agreement may have had a preclusive effect against the debtor's estate, it was not binding on the insurer. Therefore, the appeals court concluded that for the purposes of an action against the debtor's insurer based on an unreasonable refusal to settle, the bankruptcy court's approval of an uncontested claim without an evidentiary hearing provided no reliable basis to establish damages resulting from the refusal to settle.

The appeals court further found that the insurer has no obligation to appear in bankruptcy court on its own behalf to object to a claim against an insurer debtor. It ruled that an insurer's obligation under a liability insurance policy is to defend and indemnify the insured in accordance with the provision of the policy. If the insured elects not to defend against a bankruptcy claim and the bankruptcy trustee agrees with the claimants that the claim should be allowed, the insurer has no obligation to object to the claim on its own behalf. Indeed, the appeals court doubted that the insurer would even have had standing to do so.

Wolkowitz highlights the broader problem of the uneasy fit of bankruptcy and insurance. Very often, insurance is an important (if not crucial) asset of a bankruptcy estate. Substantial policy limits make tempting targets for bankruptcy trustees charged with (and compensated by) the collection of assets. All of this legal fuzziness encourages creative strategies to recover potential insurance assets in bankruptcy cases.

Here, the trustee attempted to use the bankruptcy claims allowance process as a substitute for a liability determination in the tort system as a means for triggering coverage under the insurance policy. In bankruptcy, the purpose of claim allowance is to fix the claimant's relative distribution percentage vis-à-vis other similarly situated claimants competing for a limited fund that is usually insufficient to satisfy all claims. In the tort system, however, claim allowance is to quantify the extent of the tortfeasor's financial responsibility and, in turn, its insurer's indemnity obligation. The appeals court recognized this distinction by holding that bankruptcy court allowance does not provide sufficient assurance that a stipulated claim, approved without objection and without a contested evidentiary hearing, will accurately or reliably reflect the debtor's actual liability on the claim. The trustee's creative attempt to transplant a bankruptcy concept to achieve a very different insurance result failed because the appeals court found that it violated an important insurance law policy of precluding collusive settlements.

For the insurer, one could view this case as (in the parlance of air traffic controllers) a "near miss." The insurer's decision not to object to the allowance of the claim in the bankruptcy case was not entirely risk free as, in retrospect, the appeals court seemed to indicate. The appeals court could have just as easily agreed with the trustee that the insurer, having an opportunity to object to the settlement agreement and participate in the hearing, was bound by the allowance of the claim under principles of res judicata or collateral estoppel. It would not be the first time that this has happened. See UNR Indus. v. Continental Casualty Co., 942 F.2d 1101 (7th Cir. 1991); Fuller-Austin Insulation Co. v. Fireman's Fund Insurance Co., 2002 WL 31005090 (Cal. Superior, Aug. 6, 2002).

Moreover, the appeals court's seemingly gratuitous comments about the insurer's lack of standing only add to the uncertainty regarding the extent to which insurers may participate in bankruptcy cases. In instances where a debtor or trustee attempts to adversely affect an insurer's substantive rights in a bankruptcy case, an insurer's ability to object may be the only means preventing a multi-million dollar nightmare.

Nice try.