Courts Analyze Impact of Allowed Claims on Commercial Liability Policies

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Robert S. Gebhard Partner Sedgwick LLPRobert S.  Gebhard

By Robert S. Gebhard

Robert S. Gebhard is a partner in Sedgwick LLP’s Creditors Rights and Bankruptcy Practice Group and is a member of the firm’s Cybersecurity team. He is a contributing author to Bloomberg Law: Bankruptcy Treatise. He can be reached at robert.gebhard@sedgwicklaw.com or (415) 627-1470.

This article examines two recent insurance coverage decisions involving the potential impact of the bankruptcy claims allowance process upon commercial liability policies. The decisions delve into the issue of whether an uncontested proof of a claim in an insured’s bankruptcy case can ripen into a final judgment for purposes of triggering liability coverage via the “deemed allowed” mechanism of Section 502 of the Bankruptcy Code. Although the insurance carriers prevailed in each case by successfully arguing that their policies were not triggered, the courts wrestled with fundamental questions regarding the purpose and effect of a deemed allowed claim.

What Is a Deemed Allowed Claim?

Section 502(a) of the Bankruptcy Code provides that, once filed, a proof of claim is “deemed allowed,” unless an objection is made. In turn, Section 502(b) mandates that, if any objection is made, the Bankruptcy Court “shall determine the amount of the claim and allow the claim in such amount.” However, Section 502 does not specify the purpose or effect of an allowed claim — deemed or otherwise.

In the coverage decisions discussed below, the courts confronted several threshold questions regarding the potential effect of a deemed allowed claim. Is the deemed allowance mechanism triggered in a “no asset” bankruptcy, in which no estate assets are available for distribution to creditors? Does a deemed allowed claim constitute a final judgment that is entitled to res judicata effect in subsequent litigation or proceedings? Does the answer depend on whether the bankruptcy court actually enters an order allowing the uncontested claim? Is any purported final judgment on the allowed claim the functional equivalent of an executable money judgment?

1. Kipp Flores Architects, LLC v. Mid-Continent Casualty Co., 852 F.3d 405 (5th Cir. 2017)
Facts

The claimant commenced a copyright infringement action against certain limited liability companies and their members, which was subsequently stayed upon successive bankruptcy filings by the defendants. In the bankruptcy case at issue, a Chapter 7 liquidation filed by one of the business entities, the claimant did not move for relief from the automatic stay to continue prosecuting the lawsuit. Instead, the claimant filed a proof of claim for in excess of $63 million in estimated copyright infringement damages based on the pending infringement action. The proof of claim was filed in response to a claims bar date notice issued by the bankruptcy court after the trustee filed an initial report indicating that there were potential assets to be administered for creditors.

Neither the bankruptcy trustee, nor any other party in interest, objected to the proof of the claim. The bankruptcy court entered no orders on or relating to the proof of claim. No deadlines were set by the court for the filing of any objections to proofs of claim. The bankruptcy case was subsequently closed after the trustee filed a “no asset” report confirming that no bankruptcy estate assets were available for distribution to creditors. The business entity received no Chapter 7 discharge of its debts in accordance with Section 727(a)(1) of the Bankruptcy Code.

Several years after the bankruptcy case was closed, the claimant brought a coverage action in federal district court against the debtor’s general liability insurer. The claimant alleged that its proof of claim was deemed allowed by operation of Section 502 of the Bankruptcy Code upon the closing of the bankruptcy case, which, the claimant asserted, ripened into a final $63 million judgment against the insured under principles of res judicata.

Claimant’s Specific Arguments

The claimant asserted that its proof of claim was deemed allowed in the no asset case by operation of the plain meaning of section 502(a) — even though no bankruptcy purpose would have been served by determining the claim because no assets were available for distributions to creditors. In short, Section 502(a) provides that proofs of claim are deemed allowed when filed, and the claimant argued that there is no “no asset exception” codified in Section 502(a).

The claimant further contended that its deemed allowed claim was a final judgment entitled to res judicata effect — even in the absence of any bankruptcy court order on or relating to the purportedly allowed claim. The claimant principally relied on the 9th Circuit’s decision in Siegel v. Federal Home Loan Mortg. Corp., 143 F.3d 525 (9th Cir. 1998) for its unprecedented coverage action against the carrier. In Siegel, the 9th Circuit held that a deemed allowed claim in a bankruptcy case is entitled to res judicata effect against a debtor in subsequent proceedings, regardless of whether the proof of claim was actually adjudicated on the merits or the subject of a separate court order allowing the claim. Id. at 530-31. The claimant also argued that Siegel involved a no asset bankruptcy, but, as noted by the 5th Circuit in Kipp Flores, Siegel did not discuss or address whether a proof of claim should be deemed allowed in a no asset bankruptcy. Kipp Flores 852 F.3d at 414-15.

Lower Court Proceedings

On cross-motions for summary judgment, the carrier argued that the proof of claim was neither deemed allowed in the no asset bankruptcy, nor could it constitute a final judgment against the debtor-insured for res judicata or any other purpose. After extensive briefing and oral argument, the district court granted summary judgment in favor of the carrier. The court held that the claimant held no recoverable judgment against the policy because the bankruptcy claims process was not triggered in the no asset bankruptcy. The court did not reach the second issue of whether a deemed allowed claim may constitute a judgment against the insured for purposes of insurance coverage.

The 5th Circuit Decision

The 5th Circuit affirmed the district court, holding that the claimant did not have a deemed allowed claim that was entitled to any res judicata effect. Kipp Flores, 852 F.3d at 415-16. After noting that the appeal raised “an intriguing question of statutory interpretation,” the court concluded that the text and structure of the Bankruptcy Code, Federal Rules of Bankruptcy Procedure, Official Proof of Claim Form and relevant case law all supported affirmance of the district court. Id. at 409.

The 5th Circuit specifically endorsed the insurer’s argument that the Bankruptcy Code, read as whole, provides for the claims allowance process only in asset cases in which “assets are available or are thought to be forthcoming for distribution.” Id. The court reasoned that in the no asset bankruptcy at issue “nothing in the court proceedings required claim allowance, no notice was provided to parties in interest to object to claims, and no bankruptcy purpose would have been served by the bankruptcy court’s adjudicating [the] claim.” Id at 415-16. Like the district court below, the 5th Circuit did not address the second issue of whether a deemed allowed claim may constitute a final judgment. Id. In rejecting the claimant’s novel theory, the 5th Circuit recognized the potential mischief that would be created by distorting the bankruptcy claims allowance process to require carriers or other parties in interest to monitor and object to “superfluous” proofs of claim in no asset bankruptcies in which no bankruptcy purpose would be served. Id. at 413.

The Fifth Circuit explained, “Section 502 would be significantly transformed if, under [appellant’s] reading certain ‘parties in interest’ in no asset cases would be required to monitor, object to, and litigate proofs of claim that need not even be filed. Those parties would have to invoke the claims allowance process, not to affect non-existent distributions from the debtor’s estate, but solely to prevent collateral consequences in other litigation.” Id.

2. Kerr v. American-Alternative Ins. Corp. (In re One World Adoption Servs), 571 B.R. 474 (Bankr. N.D. Ga. 2017)
Trustee Coverage Action

The bankruptcy trustee brought a coverage action against a carrier for failure to pay purported judgments entered against the insured, which were based solely on the deemed allowance of 40 proofs of claim that were filed in the insured’s Chapter 7 bankruptcy case. Unlike the Kipp Flores case, the trustee administered the bankruptcy case as an asset case, which remained open at the time of the trustee’s commencement of the coverage action in the bankruptcy court. However, just as in Kipp Flores, the trustee argued that the deemed allowance of the proofs of claim ripened into final judgments against the insured under principles of res judicata, which triggered coverage under the policy.

Bankruptcy Court Decision

The carrier moved to dismiss the action for failure to state a claim arguing, among other grounds, that the allowed proofs of claim did not constitute covered “losses” under the subject policies. The bankruptcy court granted the carrier’s motion after concluding that the “liabilities asserted in the proofs of claim are not ‘losses’ under the Policy because they do not constitute amounts awarded pursuant to judgments.” Kerr, 571 B.R. at 482. The court also granted the carrier’s dismissal motion on other coverage grounds. Id. The trustee did not appeal.

Court’s Reasoning

The bankruptcy court first questioned whether unobjected-to proofs of claim were entitled to res judicata effect in the absence of any court order allowing the claims . Id. at 483. The trustee cited decisions from the 2nd and 5th circuits for the proposition that a deemed allowed claim is entitled to res judicata effect. EDP Med. Comput. Sys. v. United States, 480 F.3d 621, 625 (2nd Cir. 2007); Bank of Lafayette v. Baudoin (In re Baudoin), 981 F.2d 736, 740 (5th Cir. 1993). However, the court readily distinguished these cases by noting that they involved the entry of actual bankruptcy court orders relating to the allowed claims. Id. at 483-84. The trustee also cited the S iegel decision, supra, but the court observed that Siegel had been criticized by many courts and had never been explicitly followed in its circuit. Id. at 485-86, citing Fisher v. Santry (In re Santry), 481 B.R. 824, 830 (Bankr. N.D. Ga. 2012).

More fundamentally, the court determined that, while in certain instances an allowed claim might be treated as a “judgment” for purposes of res judicata, the allowed claims at issue bore no resemblance to judgments covered under the policy because they were not the functional equivalent of an “executable money judgment” of the bankruptcy court adjudicating the insured’s liability. Id. at 486, citingDiamant v. Kasparian (In re S. Calf. Plastics, Inc.),165 F.3d 1243, 1248 (9th Cir. 1999); Ziino v. Baker, 613 F.3d 1326 (11th Cir. 2010).

The court reasoned that “judgments” may have different meanings depending upon the context in which they are rendered by a court. Id. Some may be an order from which an appeal lies or a final resolution of a dispute from which preclusive effect flows. Id., quoting Ziino, 613 F.3d at 1328. The court then explained that an order allowing a proof of claim does not equate to a money judgment against the debtor due to the limited purpose of the bankruptcy claims allowance process, which the court described as follows: “An allowed claim in bankruptcy … serves a different purpose than a money judgment — an allowed claim is not an attempt to recover a judgment against the debtor but to obtain a distributive share in the immediate assets of the proceeding.” Id., citing Ziino, 613 F.3d at 1328.

Final Thoughts

While the courts in Kipp Flores and Kerr decided important coverage issues, their decisions have broader implications for bankruptcy practitioners. The decisions underscore that case precedent among the circuits regarding the res judicata effect, if any, of a deemed allowed claim remains unsettled, particularly in no asset bankruptcies or in the absence of an actual court order on or relating to the proof of claim. In addition, Kerr instructs that even if a deemed allowed claim is entitled to some res judicata effect in subsequent proceedings, the allowed claim does not equate to an executable judgment against a debtor.

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