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Ruling Confirming Primacy of Federal Bankruptcy Law Over State Law Prohibiting Assignment of Insurance Policies Good News for Chapter 11 Plan Asbestos Trusts

Over the last few decades, many companies have been inundated with claims for personal injury, wrongful death, or property damage relating to the presence of, or exposure to, asbestos or asbestos-containing products. More than a few otherwise viable companies have buckled under the weight of these claims, and several of them have turned to bankruptcy as a means of addressing and managing their asbestos-related liabilities. One of the mechanisms available to a company seeking to address its asbestos liabilities is the creation of an asbestos trust through the confirmation of a chapter 11 plan of reorganization. Once such a trust is established, asbestos claims are channeled to the trust, and claimants are typically enjoined from taking any action to recover on any asbestos-related claim other than through the trust’s claims-resolution procedures.

In addressing asbestos liabilities, whether in bankruptcy or otherwise, disputes between the company and its insurers are common, if not inevitable. In In re Federal-Mogul Global Inc., a Delaware bankruptcy court was recently tasked with resolving a dispute between the debtor and its insurers. The issue was whether assignment of asbestos insurance policies to an asbestos trust established under section 524(g) of the Bankruptcy Code is valid and enforceable against the insurers, notwithstanding anti-assignment provisions in (or incorporated in) the policies and applicable state law. Despite a Ninth Circuit ruling that could be interpreted to support the insurers’ position, the bankruptcy court held that assignment of the insurance policies was proper because the Bankruptcy Code preempts any contrary contractual or state law anti-assignment provisions.

Asbestos Trusts in Bankruptcy

Section 524(g) of the Bankruptcy Code, which was added to the statute in 1994, establishes a procedure for dealing with future personal-injury asbestos claims against a chapter 11 debtor. The procedure entails the creation of a trust to pay future claims and the issuance of an injunction to prevent future claimants from suing the debtor. All claims based upon asbestos-related injuries are channeled to the trust. Section 524(g) was enacted in response to lawmakers’ concerns that future claimants – persons who have been exposed to asbestos but have not yet manifested any signs of illness – are protected, and it recognizes that these claimants would be ill-served if asbestos companies are forced into liquidation. The statute contains detailed requirements governing the nature and scope of any injunction issued under section 524(g) in connection with the confirmation of a chapter 11 plan under which a trust is established to deal with asbestos claims. Almost every section 524(g) trust is funded at least in part by the proceeds of insurance policies that the debtor has in effect to cover asbestos or other personal-injury claims. The debtor’s plan of reorganization typically provides for an assignment of both the policies and their proceeds to the trust. Such an assignment, however, may violate the express terms of the policies or applicable nonbankruptcy law.

The Estate, the Plan, and Preemption

Section 541 of the Bankruptcy Code provides that the filing of a bankruptcy case creates an estate. With some exceptions, the estate comprises all legal or equitable interests of the debtor in property as of the commencement of the case. Specifically included within this estate are all “[p]roceeds . . . from property of the estate” and “[a]ny interest in property that the estate acquires after commencement of the case.” The majority of courts have concluded that a debtor’s insurance policies are property of the bankruptcy estate.

Section 1123 of the Bankruptcy Code provides that “[n]otwithstanding any otherwise applicable nonbankruptcy law, a plan shall . . . provide adequate means for the plan’s implementation, such as . . . [a] transfer of all or any part of the property of the estate to one or more entities, whether organized before or after the confirmation of such plan . . . .” Reading sections 541 and 1123 together, it would appear that despite any otherwise applicable nonbankruptcy law that provides otherwise, a plan may provide for the transfer of property of the estate, such as an insurance policy, to an entity such as an asbestos trust established under section 524(g).

However, section 1142 of the Bankruptcy Code, which generally addresses “implementation” of a chapter 11 plan, provides that “[n]otwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition, the debtor and any entity organized or to be organized for the purpose of carrying out the plan shall carry out the plan and shall comply with any orders of the court.” Section 1142, which was implemented in 1978 together with the rest of the Bankruptcy Code, has been construed to preempt only nonbankruptcy laws relating to financial condition.

In its 2003 ruling in Pacific Gas & Electric Company v. California ex rel. California Dept. of Toxic Substances Control, the Ninth Circuit Court of Appeals interpreted section 1123’s preemption to be coextensive with section 1142’s preemption. To reach this result, the Ninth Circuit relied on two presumptions: first, Congress would not lightly preempt state law, particularly in areas of traditional state regulation, and second, absent a clear indication to the contrary, Congress would not intend to drastically change bankruptcy law and practice from the law and practice under the Bankruptcy Act – the predecessor statute to the modern Bankruptcy Code. The precursor to section 1123 under the former Bankruptcy Act did not contain any preemptive language, and the preemptive language in section 1123 was added in 1984 pursuant to what were termed “technical” rather than substantive amendments. Because of this statutory history and context, and due to a general presumption that Congress does not undertake lightly to preempt state law, the Ninth Circuit interpreted the preemptive text of section 1123 to be no more broad than the already existing “notwithstanding” clause of section 1142 of the Bankruptcy Code, which, as noted, preempts only nonbankruptcy laws, rules, or regulations “relating to financial condition.” Under this approach, a state law or contract provision prohibiting assignment of an insurance policy would not be preempted by contrary provisions in a chapter 11 plan.

The Bankruptcy Court’s Ruling in Federal-Mogul

The same issue was recently considered by the Delaware bankruptcy court overseeing the chapter 11 cases of international auto parts manufacturer Federal-Mogul Global Inc. and its 156 subsidiaries, which filed for chapter 11 protection in 2001. However, the bankruptcy court came to a different conclusion, ruling that under section 1123 of the Bankruptcy Code, the assignment of policy proceeds to an asbestos trust is not prohibited by anti-assignment provisions in insurance policies. In doing so, the court explicitly rejected the Ninth Circuit’s interpretation in Pacific Gas & Electric. In the bankruptcy court’s view, the plain language of section 1123 indicates that its preemptive scope is not limited to laws relating to financial condition. It also emphasized that section 1123, rather than other provisions of the Bankruptcy Code, was the controlling statutory provision under the circumstances.

According to the court, Pacific Gas & Electric squarely conflicts with the rationale of the Court of Appeals for the Third Circuit (which includes Delaware) in In re Combustion Engineering, Inc. and other courts that have considered the issue. Acknowledging that there is a presumption against preemption, the court explained that this presumption is overcome where Congress’s desire to preempt state law is clear. The bankruptcy court emphasized that, when read according to its plain meaning, section 1123 expresses Congress’s clear statement of intent to supersede all other laws, and an interpreting court is bound to consider first and foremost the plain statutory text. Put another way, Congress meant what it said.

The bankruptcy court further explained that it would be inappropriate to look to other sections of the Bankruptcy Code to limit the scope of section 1123. For instance, the insurers argued that section 363 of the Bankruptcy Code, which permits a debtor-in-possession to use, sell, or lease property of the estate “notwithstanding any provision in a contract, a lease, or applicable law that is conditioned on the insolvency or financial condition of the debtor,” should control under the circumstances. The bankruptcy court rejected this argument as well as the similar argument (accepted by the Ninth Circuit in Pacific Gas & Electric) that section 1142’s language should be imported into the section 1123 preemption analysis. According to the Federal-Mogul court, the controlling statutory provision is section 1123 – not section 363 or 1142 – and when Congress uses particular language in one section of a statute but omits it in another, the difference is presumed to manifest a purposeful and intentional distinction in meaning.

The insurers also argued that the insurance policies were executory contracts that could not be assigned under section 365 of the Bankruptcy Code. This argument too met with little success. The bankruptcy court concluded that the contracts were not executory (and section 365 therefore did not apply) because all premiums under the policies had been paid prepetition, and the remaining obligations under the policies (relating to cooperation, retrospective premiums, deductibles, and notice provisions) were ministerial in nature and did not render the policies executory.

Analysis

The bankruptcy court’s ruling in Federal-Mogul is a favorable development for companies wishing to address their asbestos liabilities through a chapter 11 plan of reorganization by means of the trust mechanism contained in section 524(g). Asbestos trusts, as creatures of federal law, act as successors to the debtor’s asbestos liabilities. Federal-Mogul holds that insurance policies associated with these liabilities may be transferred to these specialized trusts notwithstanding state law anti-assignment clauses to the contrary. By promoting the transferability and utility of a bankruptcy estate’s property, the holding should contribute to maximizing the value of a chapter 11 debtor’s assets and may, as a result, increase recoveries for asbestos claimants. The obvious losers in this case are the debtors’ prepetition insurers.

Although the Federal-Mogul court’s reasoning focused primarily on the plain language of the statute, the court’s interpretation of such language is not free from controversy. On the one hand, Federal-Mogul and certain of the authorities cited therein stand for the proposition that section 1123’s preemption is broad by relying on the plain meaning of the statutory text. On the other hand, the Ninth Circuit’s ruling in Pacific Gas & Electric construes the preemptive scope much more narrowly by interpreting section 1123 in light of its statutory history and context. Under Federal-Mogul’s interpretation, any applicable nonbankruptcy law is preempted, while under the Ninth Circuit’s view, only nonbankruptcy law relating to financial condition is preempted. Given these conflicting authorities, the debate concerning the scope of section 1123 will undoubtedly continue, and how courts resolve the issue going forward will be extremely important both inside and outside the asbestos context. _____________________________________

In re Federal-Mogul Global Inc., 385 B.R. 560 (Bankr. D. Del. 2008).

Pac. Gas & Elec. Co. v. California ex rel. California Dept. of Toxic Substances Control, 350 F.3d 932 (9th Cir. 2003).

In re Combustion Engineering, Inc., 391 F.3d 190 (3d Cir. 2004).
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