Insurance Coverage Claims are “Non-Core,” New Jersey Bankruptcy Court Confirms

A New Jersey Bankruptcy Court recently confirmed that questions of insurance coverage arise under state law and typically are not core matters subject to being resolved by bankruptcy courts. The authors of this article discuss the decision and its implications.

A New Jersey bankruptcy court, in In re John A. Rocco Co., Inc.,1 has ruled that insurance coverage claims brought by a Chapter 7 trustee on behalf of a Chapter 7 debtor were non-core to the debtor’s bankruptcy case. The bankruptcy court’s ruling quite correctly confirms that because the issue of coverage under an insurance policy is a question of state law that routinely arises outside the context of a bankruptcy case, it generally should be considered to be “non-core,” enabling insurers to move to withdraw the reference so that such claims can be decided by the district court.

BACKGROUND

On March 25, 2010, John A. Rocco, Inc. (the “Debtor”) filed a voluntary Chapter 11 petition (the “Petition”) in the U.S. Bankruptcy Court for the District of New Jersey. Prior to filing for bankruptcy protection, the Debtor operated as a licensed insurance brokerage in the state of New Jersey. The Debtor’s business focused on obtaining casualty insurance policies on behalf of construction, paving, septic, concrete, sanitation, trucking, and hauling businesses, and its bankruptcy filing followed a flood of litigation arising out of its alleged failure to remit premiums to carriers and bind coverage on behalf of its customers.

The bankruptcy court found cause for, and approved, the appointment of a Chapter 11 trustee. The Debtor’s Chapter 11 case subsequently was converted to a case under Chapter 7, and the Chapter 11 trustee was appointed as the Chapter 7 trustee.

On March 23, 2012, the trustee filed an adversary proceeding against Utica Mutual Insurance Company, Hartford Insurance Company of the Midwest, and Penn National Insurance Company. The trustee sought a declaratory judgment that the insurers had a duty to defend and indemnify the Debtor against claims covered under prepetition insurance policies issued to the Debtor between 2006 and 2010.

THE CLAIMS

The claims for which the trustee sought coverage fell into three general categories.

The first category was liabilities arising out of the Debtor’s alleged failure to remit premiums (“Creditor Claims”). Because coverage allegedly was never bound, many of the Debtor’s customers alleged that they were left uninsured against casualty claims brought against them by third parties. Customers and premium financing companies commenced litigation against the Debtor as early as 2007 seeking to recover the return of premium payments or damages for losses sustained due to the alleged lapses in and/or failure to obtain coverage. Additionally, approximately 75 complaints were filed against the Debtor with the New Jersey Department of Banking and Insurance.

The trustee asserted that Utica had an obligation to defend and indemnify the Debtor against the Creditor Claims pursuant to errors and omissions liability insurance policies (the “Utica Policies”) issued between 2006 and 2010. The trustee also asserted that Hartford was obligated to defend and indemnify the Debtor against the Creditor Claims pursuant to business liability and employment practices liability policies (the “Hartford Policies”) in effect between 2006 and 2011, and that Penn National was obligated to provide coverage for the Creditor Claims pursuant to umbrella policies in effect between 2007 and 2010.

The second category of claims for which the trustee sought coverage was for losses allegedly caused by unauthorized transfers made by former employees of the Debtor. According to the trustee, the Debtor’s principal, John D. Rocco (“Rocco”), and another employee, Kelly Roetto (“Roetto”), transferred for their own personal benefit nearly $5.5 million in funds belonging to the Debtor during the four year period preceding the bankruptcy filing. The trustee also alleged that $15,238 was transferred to Rocco and $9,510 was transferred to Roetto during the postpetition period prior to the onversion of the case to Chapter 7. The trustee asserted that losses caused by these unauthorized transfers were covered by an “Employee Dishonesty Coverage Form” included in the Hartford Policies.

The final category of claims consisted of claims of four former employees of the Debtor for the return of contributions made to their 401(k) employee benefit plans. The trustee sought a determination that these claims, which were for a total of $45,000, were covered under the “Employee Benefits Liability Coverage” provision of the Hartford Policies.

THE COUNTS

The insurers moved for a determination that Counts One through Three and Counts Six and Seven of the trustee’s complaint were “non-core” proceedings. (The insurers did not dispute that Count Four, which sought damages for an alleged violation of the automatic stay, was a core proceeding; Count Five, which sought a declaratory judgment that another party was obligated to indemnify the Debtor pursuant to a dishonesty bond, was resolved on consent.)

In particular, Count One sought a declaratory judgment that Utica was obligated to defend and indemnify the Debtor against Creditor Claims arising out of its failure to remit premiums.

Count Two asserted that Utica breached its contract with the Debtor by refusing to provide defense costs and indemnity under the Utica Policies.

Count Three sought indemnity from Utica for any covered losses.

Count Four alleged that the postpetition cancellation of a Utica Policy violated the automatic stay as an “act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.” (Utica contended that the stay was not violated because it had mailed notice of cancellation of the policy to the Debtor prepetition and the policy cancelled on its own terms postpetition due to the Debtor’s failure to make premium payments.)

Count Six sought a declaratory judgment that Hartford was obligated to defend and indemnify the Debtor for losses under business liability and employment practices liability policies in effect between 2006 and 2011.

Count Seven sought a declaratory judgment that Penn National was obligated to provide coverage for Creditor Claims under umbrella insurance policies effective between February 2007 and February 2010.

THE PARTIES’ ARGUMENTS

The insurers argued that the trustee had presented “garden variety state law claims” that fell outside of bankruptcy court “core” jurisdiction. The insurers indicated that they sought a non-core determination because they intended to move to withdraw the reference and remove the action to the district court.2

In response, the trustee argued that his complaint was a core proceeding because it involved postpetition breach of contract claims. At a minimum, the trustee asserted that Counts One through Three were core because the issue of whether there was coverage under the Utica Policies could not be separated from the claim in Count Four that Utica had violated the automatic stay by allegedly cancelling a policy after the Debtor had entered bankruptcy; the parties agreed that Count Four was a core proceeding.

THE BANKRUPTCY COURT’S DECISION

In its decision, the bankruptcy court explained that its jurisdiction over the adversary proceeding brought by the trustee was governed by 28 U.S.C § 157(b), which limits bankruptcy court jurisdiction to “all cases under title 11 and all core proceedings arising under title 11, or arising in a case under title 11.”3 The bankruptcy court pointed out that although Section 157(b) does not specifically define “core proceedings,” it does provide a non-exhaustive list of proceedings that may be core.4

The bankruptcy court then stated that core proceedings could be understood as “actions by or against the debtor that arise under the Bankruptcy Code in the strong sense that the Code itself is the source of the claimant’s right or remedy, rather than just the procedural vehicle for the assertion of a right conferred by some other body of law, normally state law.”

The bankruptcy court then turned to the two-part test adopted by the U.S. Court of Appeals for the Third Circuit in Halper v. Halper5 to determine whether a proceeding was core.6 Under this test, as the bankruptcy court observed, courts first determine whether the proceeding is listed among the non-exhaustive list of core proceedings described in Section 157(b)(2). Then, courts decide whether the claim invokes a substantive right provided by the Bankruptcy Code or “if it is a proceeding, that by its nature, could arise only in the context of a bankruptcy case.”

As the bankruptcy court noted, if a claim satisfies both steps of the Halper test, it is “core” and the bankruptcy court has the power to hear the matter and enter final judgments. By contrast, if a claim does not invoke a substantive right provided by the Bankruptcy Code or can arise outside the context of a bankruptcy case, it is “non-core” and, in the absence of the consent of the parties, the bankruptcy court’s authority is limited to submitting proposed findings of facts and conclusions of law to the district court.7

The bankruptcy court then examined each count of the trustee’s complaint to determine whether the adversary proceeding was core.

Counts One through Three

The bankruptcy court first considered Counts One through Three, relating to insurance coverage under the Utica Policies.

The bankruptcy court pointed out that because the issue of coverage under an insurance policy was a question of state law “that routinely arises outside the context of a bankruptcy case,” claims for insurance coverage typically were considered “non-core.”8 It then found that, on the face of the trustee’s complaint, Counts One through Three did not assert anything other than “ordinary insurance coverage claims.”

The bankruptcy court acknowledged the trustee’s argument that these counts were core because they involved postpetition claims for damages that could not be separated from the claim for a violation of the automatic stay, and said that there was at least some support for the trustee’s view that the timing of a claim was relevant to the core determination.9 The bankruptcy court then decided that, even if it accepted the trustee’s position and considered the timing of the claim as relevant to the core determination, Counts One through Three still were non-core.

The bankruptcy court reasoned that the trustee’s characterization of the proceeding as a postpetition breach of contract dispute was “not entirely accurate.” The bankruptcy court said that even assuming that the Debtor had a valid breach of contract claim based on an alleged postpetition cancellation of the policy, the remaining claims in Counts One through Three consisted of insurance coverage claims arising out prepetition events and losses. The bankruptcy court stated:

These claims clearly could not “arise only in the context of a bankruptcy case” since litigation involving these claims began as early as 2007 . . . . The fact that some of the Creditor Claims were not asserted until after the petition is irrelevant because even these claims arise from the same [prepetition] losses that the Debtor and/or Utica were litigating well before the [p]etition was filed.

The bankruptcy court added that the majority of the claims for which the trustee sought coverage existed well before the Debtor’s bankruptcy case was filed and the coverage issue did “not merely turn on the relatively narrow question of whether cancellation was proper.” Rather, the bankruptcy court decided, it involved “more complicated issues of state law governing the interpretation of the terms, conditions, limitations, and exclusions of insurance policies.”

The bankruptcy court also observed that the coverage claims did not affect the administration of the Debtor’s bankruptcy estate because the Debtor’s case had been converted to a case under Chapter 7 years ago and little remained to be administered except for the liquidation of the Debtor’s assets.

The bankruptcy court also rejected the trustee’s argument that Counts One through Three were core because they were factually intertwined with Count Four, which asserted a violation of the automatic stay. The bankruptcy found that the alleged postpetition cancellation of the policy was a “wholly separate question from whether the Creditor Claims are covered under the policies.”

The bottom line, the bankruptcy court declared, was that Counts One through Three presented the kind of claims that the U.S. Supreme Court has held that bankruptcy courts may not adjudicate to final judgments.10 The bankruptcy court said that the question of coverage under the policies was “entirely one of state law, and whatever rights the Debtor may have to coverage under the policies arose independent of and antecedent to the bankruptcy.”  Moreover, the bankruptcy court noted, even taking into consideration the timing of the claims (which it said that it did not have to do under Halper), the claims for coverage under the Utica Policies “existed when the losses occurred and the substantive rights provided under the Bankruptcy Code have no effect on these claims.” Thus, Counts One through Three were noncore.

Counts Six and Seven

The bankruptcy court reached the same conclusion with respect to Counts Six and Seven. The bankruptcy court applied the same analysis that applied to the Utica Policies to the coverage of the Creditor Claims under the Hartford and Penn National policies. Similarly, it stated, the unauthorized transfer claims were based almost entirely on prepetition conduct and prepetition losses. It said that although the alleged fraudulent conduct may have continued, to a limited extent, after the bankruptcy petition was filed, the Debtor “owned the right to coverage for these losses (if it owns that right at all) at the time of the bankruptcy.”

Moreover, the bankruptcy court added, although the employee benefits coverage claims were not asserted until after the Petition was filed, the obligation to return the contributions, and thus any right to coverage for these obligations, accrued entirely prior to the bankruptcy filing.

The bankruptcy court concluded that these claims were not core because they arose independent of and antecedent to the bankruptcy filing and could have been asserted outside of bankruptcy.

CONCLUSION

The bankruptcy court’s decision in Rocco confirms that questions of insurance coverage arise under state law and typically are not core matters subject to being resolved by bankruptcy courts. When debtors seek bankruptcy protection and insurance coverage claims are in dispute, carriers are likely to rely on Rocco that the claims are not core and, then, seek to withdraw the reference and remove the insurance coverage dispute to the district court.

1 2015 Bankr. LEXIS 1283 (Bankr. D.N.J. Aprl. 13, 2015).

2 See 28 U.S.C. § 157(d).

3 28 U.S.C § 157(b)(1).

4 28 U.S.C. § 157(b)(2) provides:

Core proceedings include, but are not limited to—

(A) matters concerning the administration of the estate;

(B) allowance or disallowance of claims against the estate or exemptions from property of the estate, and estimation of claims or interests for the purposes of confirming a plan under chapter 11, 12, or 13 of title 11 [11 USCS §§ 1101 et seq., 1201 et seq., or 1301 et seq.] but not the liquidation or estimation of contingent or unliquidated personal injury tort or wrongful death claims against the estate for purposes of distribution in a case under title 11;

(C) counterclaims by the estate against persons filing claims against the estate;

(D) orders in respect to obtaining credit;

(E) orders to turn over property of the estate;

(F) proceedings to determine, avoid, or recover preferences;

(G) motions to terminate, annul, or modify the automatic stay;

(H) proceedings to determine, avoid, or recover fraudulent conveyances;

(I) determinations as to the dischargeability of particular debts;

(J) objections to discharges;

(K) determinations of the validity, extent, or priority of liens;

(L) confirmations of plans;

(M) orders approving the use or lease of property, including the use of cash collateral;

(N) orders approving the sale of property other than property resulting from claims brought by the estate against persons who have not filed claims against the estate;

(O) other proceedings affecting the liquidation of the assets of the estate or the adjustment of the debtor-creditor or the equity security holder relationship, except personal injury tort or wrongful death claims; and

(P) recognition of foreign proceedings and other matters under chapter 15 of title 11.

5 164 F.3d 830 (3rd Cir. 1999).

6 The test adopted in Halper was based on the test adopted by the U.S. Court of Appeals for the Fifth Circuit in In re Wood, 825 F.2d 90 (5th Cir. 1987), which held that “a proceeding is core under section 157 if it invokes a substantive right provided by title 11 or if it is a proceeding that, by its nature, could arise only in the context of a bankruptcy case.”

7 See 28 U.S.C. § 157(c)(1).

8 See, e.g., In re United States Brass Corp., 110 F.3d 1261 (7th Cir. 1997) (reasoning that “the claimed right to insurance coverage is a creation of state contract law and one that could be vindicated in an ordinary breach of contract suit if [the insured] were not bankrupt.”); Sullivan v. Maryland Cas. Co. (In re Ramex Int’l, Inc.), 91 B.R. 313 (E.D. Pa. 1988) (holding that trustee’s action for declaratory judgment under insurance policy issued prepetition was non-core); In re G-I Holdings, Inc., 278 B.R. 376 (Bankr. D.N.J. 2002) (noting that an insurance coverage action “bears no resemblance” to other examples of core proceedings).

9 See, e.g., In re Stone and Webster, 367 B.R. 523 (Bankr. D. Del. 2007) (“Another factor that is relevant to the determination of whether a proceeding is core or non-core is the time period in which the underlying claim arises.”). Other courts, including the U.S. Court of Appeals for the Second Circuit, have expressly included the timing of a claim as a relevant consideration under their core tests. See In re Ben Cooper, 896 F.2d 1394 (2nd Cir. 1990). But see, In re G-I Holdings, 278 B.R. at 382 (noting that the Third Circuit test for core jurisdiction was narrower than the tests applied in other circuits and that considerations such as “whether the action was commenced after the filing of the petition” and “whether the contract is antecedent to the reorganization petition . . . do not play a role under this circuit’s core test.”).

10 See Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50, 102 S. Ct. 2858, 73 L. Ed. 2d 598 (1982).

Reprinted with permission from Pratt’s Journal of Bankruptcy Law.  All rights reserved.