Close Doesnt Count in Horseshoes Hand Grenades and Section 541 Disputes Over Insurance Policy Proceeds

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Feb 2003

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A recent Fifth Circuit decision affirms the old adage that "close doesn't count" even when it appears that in
the name of equity, it should. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… re Equinox Oil Co. Inc., 300 F.3d 614 (5th Cir., 2002)</a>, a group of
creditors provided unsecured loans to a chapter 11 debtor for the noble purpose of cleaning up an oil spill.

However, this same group of creditors was ultimately forced to equally share the proceeds from an
insurance policy that reimbursed the debtor for the costs and damages resulting from the oil spill with
other unsecured creditors who had no direct part in effectuating the clean-up of the oil spill. This outcome
was the result of the Fifth Circuit holding that these insurance proceeds were property of the debtor's estate
rather than property of the group of unsecured creditors who helped directly finance the oil spill clean-up.

Equinox Oil actually involved appeals of decisions in two separate but related adversary
proceedings. However, this article focuses solely on the Fifth Circuit's decision regarding the appeal
dealing with whether the proceeds of the debtor's well-control insurance policy were included in the
property of the debtor's estate.

Equinox operated oil and gas leases owned by Alma Energy Corp; the two companies had
common ownership. In September 1998, a blow-out happened at an oil well on an Equinox lease near Port
Sulfur, La. This blow-out caused extensive property damage and resulted in an oil spill. Equinox notified
its insurer, National Union Fire Insurance Co., of the oil spill and the related property damage. Several
companies provided services and equipment (the remediation creditors) to Equinox to stop the blow-out
and clean up the spill. Equinox presented a proof of loss form to National Union, who subsequently paid
Equinox in excess of $700,000 in partial settlement of the insurance claim related to the clean-up. In turn,
Equinox paid some companies a portion of what they were owed. However, Equinox did not repay many
of its debts to the remediation creditors.

In May 1999, some of Equinox's creditors forced Equinox into an involuntary chapter 7 bankruptcy.
Subsequent to the filing of the involuntary petition, Equinox converted its case to chapter 11. In an
adversary proceeding stemming from the Equinox bankruptcy, the bankruptcy court determined that the
National Union insurance proceeds were not property of the bankruptcy estate. However, the district court
reversed. An appeal of the district court decision was filed with the Fifth Circuit, who heard the matter and
subsequently issued its decision on Aug. 12, 2002.

The main issue on appeal to the Fifth Circuit was whether the proceeds from Equinox's insurance
policy for well control were property of its bankruptcy estate. The remediation creditors argued that because
the well-control policy covered Equinox for the cost of the services that they provided in the oil spill
clean-up, the proceeds of that policy should be disbursed directly to them and excluded from Equinox's
estate. In contrast, the unsecured creditors' committee argued that the proceeds should be included in the
debtor's bankruptcy estate and therefore be shared pro rata by all of the general unsecured creditors.

In forming its decision, the court began with an analysis of §541 of the Bankruptcy Code. Section
541 defines bankruptcy estate property to include "all legal and equitable interests of the debtor in property
as of the commencement of the case" and "proceeds...of or from property of the estate." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… U.S.C.
§541(a)(1)</a> and (6). Courts read §541 broadly and have interpreted it to "include all kinds of property,
including tangible or intangible property, causes of action...and all other forms of property currently
specified in §70a of the Bankruptcy Act." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… States v. Whiting Pools Inc., 462 U.S. 198, 204-05 & n.
9, 103 S.Ct. 2309, 2313 & n. 9, 76 L.Ed.2d 515 (1983)</a>.

Next, the court proceeded to review how §541 specifically applies to insurance policies. The court
set forth the general test, which states that the court must look at whether the proceeds of the insurance
policy would belong to the debtor when the insurance company paid the claim. The court obtained this
general test by relying on two Fifth Circuit cases that also addressed the issue of whether insurance
proceeds are part of a debtor's bankruptcy estate. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… re Edgeworth, 993 F.2d 51 55 & n. 13 (5th Cir.
1993)</a>, and <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… re Louisiana World Exposition Inc., 832 F.2d 1391 (5th Cir. 1987)</a>. Both cases were
consistent in their approach to resolving the §541 issue.

In addition to Fifth Circuit precedent, the court also looked at the Collier Bankruptcy Manual to
address the issue, noting that the views in Collier were consistent with the positions taken in Fifth Circuit
precedent. Section 541.11 of Collier notes that "[i]t is well established that money payable as the proceeds
of a fire policy taken out before bankruptcy for the debtor's benefit does not arise from the property, but
from a personal contract between insurer and insured." Therefore, absent a "loss payable" rider or other
contractual modification, the proceeds of such a policy are property of the estate. The court found this
analysis to go hand-in-hand with prior Fifth Circuit precedent.

In addition to relying on the consistent general test, the court also referred to the specific facts of
each case. In In re Louisiana World Exposition Inc., the court decided that the proceeds of a director and
officer liability policy were not part of the debtor's bankruptcy estate. In that case, Louisiana World
Exposition (LWE), the debtor, bought insurance policies that provided liability coverage to its officers and
directors for liabilities and related legal expenses the officers and directors might incur in relation to their
services to LWE. In addition, these policies indemnified LWE to the extent the corporation might be
mandated to reimburse the directors and officers for any legal expense or liability. The directors and
officers, not LWE, were the insureds under the policy. Therefore, the court in Louisiana World Exposition
concluded that the debtor had no type of ownership interest in the proceeds of the liability coverage; rather,
the obligation of the insurance companies was solely to the directors and officers.

The court also reviewed the specific facts in In re Edgeworth. This case involved ownership of
medical malpractice insurance policy proceeds. A plaintiff sued for medical malpractice seeking recovery
from Dr. Edgeworth's insurance carrier after the debtor, the insured under the policy, had received his discharge. Therefore, the issue in Edgeworth was whether the discharge acted to bar the suit if the plaintiff
agreed to renounce recovery from the debtor personally and only look to the policy proceeds. Finding that
the release of the debtor did not affect the liability of the insurer, the court in Edgeworth considered
whether the insurance proceeds were property of the estate, stating:

<blockquote>
The overriding question when determining whether proceeds are property of the estate is whether
the debtor would have a right to receive and keep those proceeds when the insurer paid on a claim.
When a payment by the insurer cannot 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.
</blockquote>

Id. at 55-56. The court in Edgeworth went on to give examples of insurance policies whose proceeds were
property of the estate, listing casualty, collision, life and fire insurance policies in which the insured
debtor was a beneficiary (emphasis added). In contrast, the court gave an example of a policy whose
proceeds were not bankruptcy estate property, noting that liability policy proceeds that are ordinarily
payable only for the benefit of those harmed by the insured debtor would not be property of the estate. In
the end, the court observed that Dr. Edgeworth had not made a claim on the proceeds of his medical
malpractice liability policy. For that reason, the court concluded that proceeds of Dr. Edgeworth's liability
policy were not property of the chapter 7 estate. See, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… re Vitek Inc., 51 F.3d 530 (5th Cir.1995)</a>.

The court relied on the preceding general test and fact patterns from Fifth Circuit precedent in its
analysis of the facts in Equinox. First, the court distinguished the difference between the insurance policy
beneficiary in this case and the insurance policy beneficiaries in the two prior cases. Under the terms of the
policy in this case, the underwriter agreed "to reimburse the assured" (emphasis added) for expenses
relating to well blowouts, including costs to put out fires and costs to re-establish control of the well, not
the debtor. Second, the court noted that Equinox's policy with National Union was particularly analogous
to a standard fire policy because fire policies also reimburse the insured for repairs to the insured's
fire-damaged property after a blaze. This analogy was important because it allowed the court to consider the
National Union policy to be grouped within the list of "estate, casualty, collision, life and fire insurance
properties" classified in Edgeworth as types of §541 property. Id. at 56.

Based solely on the foregoing factors, it appears that the answer to the question of whether the
insurance proceeds are estate property under §541 of the Code would be a slam dunk in favor of the
committee and that the remediation creditors had no rights under the policy to claim its proceeds.
However, unlike its prior two decisions dealing with the issue, the Fifth Circuit in Equinox had to address
a somewhat compelling argument from the remediation creditors that contained some "equitable tug." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…;

at 619</a>. The remediation creditors argued that the services they provided that helped to stop the blow-out
and clean up its after-effects represented the identical basis of Equinox's claim against National Union.
Therefore, the remediation creditors proposed that it was unfair to group them with the rest of the
unsecured creditors whose claims had nothing substantively to do with the insurance proceeds.

While the court acknowledged that the remediation creditors' argument had an "equitable tug," it
nonetheless ruled against the remediation creditors because they were just like any other unfortunate
creditor who has an unsecured claim that cannot be classified as a priority claim under state law or the
Code. First, the remediation creditors may not be as special as they imply. For example, the court pointed
out that other unsecured creditors, such as banks that made unsecured loans to the debtor who in turn used
such loan proceeds to conduct the clean-up and suppliers that sold clean-up supplies to the debtor, would
get less than the remediation creditors under their argument, even though their debts were incurred for the
same cause. Second, the court noted that the remediation creditors could have protected themselves by
insisting that Equinox get a "loss payee" endorsement in their favor from National Union before starting
their work. Such an endorsement could have salvaged their right to the policy proceeds.

Equinox makes it clear that a creditor cannot utilize a bankruptcy version of the Kevin Bacon
Degrees of Separation Game to argue that the nature of its claim is close enough in relation to the proceeds
in dispute amongst the creditors of the bankruptcy estate by virtue of the nature of the claim against the
insurance policy that resulted in the proceeds being paid. While such an argument appears equitable on the
surface, the legal reality is that creditors must rely on the specific language of the insurance policy related
to the environmental disaster that identifies the beneficiary of the policy's proceeds for the purpose of
determining what share of such proceeds the creditor should receive.

However, Equinox also makes it clear that a creditor who helps finance the business entity
responsible for the clean-up of an environmental accident like an oil spill can protect itself from being
stuck with the rest of the general unsecured creditors in the event the business entity that caused the
accident subsequently files for bankruptcy. Specifically, the Fifth Circuit suggests that such a creditor
should have the potential debtor-entity incorporate a loss-payable clause into the insurance policy that
would designate them as the beneficiary of the insurance policy proceeds to the extent of the clean-up costs
that the creditor was already financing de facto. Such an arrangement would change the way courts like the
Fifth Circuit would perform their §541 analysis, as they would likely hold that loss payee proceeds would
not be property of the bankruptcy estate because the creditor, rather than the debtor, is the loss-payee
beneficiary of the policy proceeds.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Board-certified in business bankruptcy by the American Board of Certification. <a href="#1a">Return to article</a>

Journal Authors

Andrew D. Stosberg

John W. Ames

Journal Date

Saturday, February 1, 2003 - 12:00

Bankruptcy Rule

2003