AXATION and REGULATION of

FINANCIAL INSTITUTIONS • Roadmapping the Future of Corporate Tax Work Product After

Textron

• Final FBAR Regulations: Navigating the Complex Requirements of Reporting Foreign Bank Accounts

• Protecting Lender Interest in Insurance Proceeds: Bankruptcy and UCC Considerations

Recent Reforms and Developments in Mortgage Law and Finance

• Directors and Officers Insurance Coverage After Dodd-Frank

U.S./International: European Commission Proposes One-Stop Method of Preserving Funds

CRI Civic Research Institute

I

Protecting Lender Interest in Insurance Proceeds: Bankruptcy

and UCC Considerations Lender expectations can be severely disrupted by the failure to give appropriate attention to perfecting interests in insurance

proceeds. There are steps that commercial lenders and other financial institutions can take, however, to prevent the impairment of their interests. This article sets out the fundamentals of bankruptcy for lenders, explains their obligations

under the law, and suggests effective controls that lenders can implement to verify perfection at the earliest commercially , reasonable point in time.

JOHN EGGUM

Commercial lenders and other financial institu­tions generally hold an interest in insurance proceeds related to collateralized obligations

of their borrowers. Protecting that interest from be­ing impaired by an obligor's bankruptcy is an es­sential aspect of maintaining the value of a financial institution's security. Similarly, ensuring that trans­actions governed by the Uniform Commercial Code (UCC) do not adversely affect lender interest in in­surance proceeds is imperative for financial institu­tions. This article provides an overview for lenders and their counsel of some fundamental aspects of bankruptcy and UCC law that may affect lenders' interests in insurance proceeds, and also examines how lenders' expectations can be disrupted by the failure to maintain strict controls relating to the insurance of their collateral. Ensuring compliance with bankruptcy-related and UCC obligations is an important aspect of lenders' ability to seek recourse from their collateral, and diligent attention to these obligations can assist in reducing losses when bor­rowers become insolvent.

Mr. Eggum is an attorney in the Chicago office of Butler Pappas Weihmuller Katz Craig LLP. His practice focuses on restructuring and insolvency-related matters, insurance coverage, and commercia/litigation. He may be contacted at jeggum@butlerpappas.com.

November/December 2011 Vol 25 I No 2

BANKRUPTCY FUNDAMENTALS FOR LENDERS When a borrower files for bankruptcy, several things happen simultaneously.1 Attempts to collect debts from the debtor-borrower are automatically stayed, all of the debtor's property is transferred to a legal construct called the "estate," and the person or en­tity with authority to make decisions concerning the debtor-borrower's property may change.

Automatic Stay. The "automatic stay" is the bankruptcy concept that is probably universally familiar to commercial lenders, since a large number of bankruptcies are filed to prevent such lenders from exercising their rights as secured creditors.2

When a bankruptcy petition is filed, Section 362 of the Bankruptcy Code imposes what is essentially an injunction that prevents creditors from taking any action or employing any process in an attempt to

1 Unless otherwise noted, all chapter, section, and rule refer­ences herein are to the Bankruptcy Code, 11 U.S.C. §§ 101-1532 ("Code"), and the Federal Rules of Bankruptcy Procedure, Rules 1001-9037.

2 Melissa B. Jacoby, "Bankruptcy Reform and Homeownership Risk," 2007 U. Ill. L. Rev. 327 (2007); Shannon C. Bogle, "Bonner Mall and Single-Asset Real Estate Cases in Chapter 11: Are the 1994 Amendments Enough?," 69 S. Cal. L. Rev. 2163,2163-2164 ( 1996). See also John Eggum, Katherine M. Porter, & Tara Twomey, "Saving Homes in Bankruptcy: Housing Affordability and Loan Modification," 2008 Utah L. Rev. 1123 (2008).

PRO TE CTI NG LENDER I NTER ES T IN INSURANCE PROC EEDS 33

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collect pre-petition debts owed by the debtor. 3 This includes staying the commencement or continuation of any judicial processes, such as the filing of foreclosure cases, and preventing the judicial (or non-judicial) auction of the debtor-borrowees property.

This existence of the automatic stay-often acknowledged by courts as intended to provide a "breathing spell" for the debtor4-can lull secured creditors into believing that all activity relating to their collateral is stayed unless they receive notice to the contrary. This is not necessarily so. The automatic stay only affects creditors; it does not affect actions taken by the debtor. Accordingly, the debtor is free to make claims under insurance policies and take other actions to collect monies owed to it.

If a debtor-borrower tenders a claim to its insurer and the lender has not properly perfected its interest,

the lender might not receive notice that a claim has been made. Simply monitoring the bankruptcy pro­ceedings is insufficient to protect the lender because the insurer might not be aware that the debtor­borrower filed for bankruptcy protection.5 In such a case, the insurer would adjust the claim in the ordi­nary course, and, because the lender has overlooked its responsibilities relating to its collateral, the-insurer may end up paying the debtor-borrower directly, with­out regard to the lender's interest. This would make recovering the lender's interest in the proceeds of the insurance policy difficult, if not impossible.

The Estate. The filing of a bankruptcy case creates an estate, comprised of all legal and equitable interests

3 11 U.S.C. § 362(a). See generally David P. Stromes, "The Extraterritorial Reach of the Bankruptcy Code's Automatic Stay," 33 Brook. J. Int'l L. 277, 277-283 (2007).

4 In re Schaefer Salt Recovery, Inc., 542 F.3d 90, 100 (3d Cir. 2008) ("The purpose of the automatic stay is to afford the debtor a 'breathing spell' by halting the collection process .... It enables the debtor to attempt a repayment or reorganization plan with an aim toward satisfying existing debt .... It also benefits creditors by preventing certain creditors from acting unilaterally to obtain payment from the debtor to the detriment of other creditors.") (internal quotations and citations omitted).

5 If the debtor did not list the insurer as a creditor on the debtor's bankruptcy schedules, the insurer would generally not receive notice of the bankruptcy. In many cases, a debtor's insurer is not a creditor, and therefore the debtor would be under no obligation to notify its insurer that it filed for bankruptcy protection.

of the debtor in property, wherever located and by whomever held.6 Thus, in addition to brick-and­mortar collateral in which lenders have an interest, the debtor's insurance policies also become property of the bankruptcy estate. In many cases, the debtor's insurance policies represent the only source of funds that may come into the estate, 7 which can lead to controversies between the lender and the estate's representative.

Proper Estate Representative. The three chapters of the Bankruptcy Code that commercial lenders commonly deal with are Chapter 7 (liquidation cases), Chapter 11 (reorganization/asset sales and occasionally liquidation), and Chapter 13 (individual debtor reorganization/repayment-plan bankruptcy). The identity of the estate representative varies, depending on which type of bankruptcy filing is involved:

• Chapter 7: In a Chapter 7 case, a trustee is appoint­ed to collect, liquidate, and equitably distribute all non-exempt property of the bankruptcy estate to the debtor's creditors. 8 If a loss has occurred (or occurs during the pendency of the bankruptcy)9

with respect to property in which a lender has an interest, the lender should be aware that the trust­ee, rather than the debtor-borrower, will be the proper party to make a claim under any applicable insurance policy. The Chapter 7 trustee will also be the party charged with investigating and, if appro­priate, challenging whether the lender's interest in insurance proceeds is properly perfected.10

6 11 U.S.C. § 541(a) ("The commencement of a case ... creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held ... (1) all legal or equi­table interests of the debtor in property as of the commencement of the case.").

7 Not all insurance proceeds will come into the estate; only those proceeds that would otherwise be payable to the debtor­borrower become property of the estate. See infra note 9.

8 11 U.S. C. § § 701-704. The trustee has broad powers to reach property of the estate-he can file lawsuits to force a third-party to turn over property of the estate and, under certain circumstances, can claw-back payments and other transfers made to third parties. See 11 U.S.C. §§ 542, 544, 545, 547, 548, 550, 551.

9 To the extent that proceeds from a debtor's insurance poli­cies are payable to the debtor, those proceeds are property of the estate, without regard to the date of loss. 11 U.S.C. § 541(a)(6). See Houston v. Edgeworth (In re Edgeworth), 993 F.2d 51, 55-56 (5th Cir. 1993). See also In re Doug Baity Trucking, Inc., 2005 WL 1288018, No. 04-13537 (Bankr. M.D.N.C. April21, 2005) (unreported).

10 Primarily, this is because Chapter 7 bankruptcy trustees owe a fiduciary duty to all creditors of the estate, including unsecured creditors. Dye v. Brown (In re AFI Holding, Inc.), 530 F.3d 832, 844 (9th Cir. 2008). To the extent that the trustee can show the lender does not have a right to insurance proceeds, this will increase the pool of money available for distribution to other estate creditors. 11 u.s.c. §§ 506, 726.

34 JOURNAL OF TAXATION AND REG ULATION OF FINANCIAL INS TITUTION S November/December 2011 Vol 25 I No 2

• Chapter 11: In a Chapter 11 case, no trustee is appointed; the debtor-borrower remains in posses­sion of all of the property of the bankruptcy estate. Under Chapter 11, the debtor has to file a "plan" that meets numerous requirements; if that plan is approved ("confirmed") by the bankruptcy court, the debtor's creditors are bound by the plan's pro­visions with respect to the debts owed to them. 11

To implement and consummate its plan, the debtor is permitted to exercise the powers that would normally be held by a trustee (in bankruptcy ter­minology, the debtor is the "Debtor-in-Possession" or "DIP"). As DIP, the debtor-borrower holds the power to investigate and challenge a lender's inter­est in insurance proceeds.12 The debtor-borrower could lose the right to exercise the powers of a bankruptcy trustee, but such removal (which would result in a separate trustee being appointed) is done only for cause, which is a rarity.13 Accord­ingly, it is likely that a lender will deal directly with the debtor-borrower in a Chapter 11 case with respect to the collection of insurance proceeds relating to lender collateral.

• Chapter 13: In a Chapter 13 case, the debtor enters into a three-to-five year plan to repay his or her creditors.14 Although a trustee supervises the debtor-borrower, the debtor-borrower retains the right to deal with property of the estate, includ­ing pursuing any insurance claims. Lenders should ensure that the Chapter 13 trustee is copied on correspondence relating to insured lender collateral in order to confirm that the bankruptcy trustee will not seek to force the debtor to modify the repay­ment plan on account of proceeds the debtor-bor­rower might receive.

MAINTAINING THE STATUS QUO: PERFECTED LENDER INTEREST PRESUMPTIVELY UNAFFECTED

Properly Perfecting the Lender's Interest. Notwithstanding the significant effects of a debtor­borrower's bankruptcy, the Bankruptcy Code is structured to leave a lender's properly perfected interest in insurance proceeds unaffected by the bankruptcy. Although bankruptcy law is federal (and thus uniform throughout the United States), the Code looks to the

11 11 U.S.C. §§ 1123, 1129, 1141 ([T]he provisions of a con­firmed plan bind the debtor ... and any creditor ... whether or not such creditor ... has accepted the plan.").

12 11 u.s.c. §§ 1106, 1107. 13 11 u.s.c. § 1104. 14 Chapter 13 is not available to corporations or other entities.

11 U.S.C. § 109(e).

November/December 2011 Vol 25 1 No 2

law of the individual states to determine the nature and extent of the lender and debtor-borrower's property rights, including whether the lender has a properly perfected interest.15 Following the traditional rules applied in federal courts, the law of whatever state would normally apply to the interpretation of the insurance policy is applied in bankruptcy.16

As a general proposition, "perfecting" an inter­est in insurance proceeds is quite simple. The lender must merely be denominated as the "loss payee" or the "mortgagee" in the actual policy (or under an endorsement), with respect to the insured col­lateral.17 States have uniformly rejected any more formal approach, relying on the familiar rationale that insurance policies are simply contracts, subject to customary rules of contract interpretation. 18 Ac­cordingly, so long as the policy indicates an intent to give the lender an interest in the proceeds of the policy as a loss payee or mortgagee, no particular clause or wo~ds are required. 19 Furthermore, there are no "fil­ing" or "public notice" requirements for perfection, as is the case under the UCC.20

15 See Butner v. United States, 440 U.S. 48, 54-55 (1979) ("Property interests are created and defined by state law .... Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding .... The justifications for application of state law are not limited to owner­ship interests; they apply with equal force to security interests.") (citation omitted).

16 See Erie R. Co. v. Tompkins, 304 U.S. 64 (1938). See also United States v. Fleet Bank of Mass. (In re Calore Exp. Co., Inc.), 288 F.3d 22, 43-44 (1st Cir. 2002) (applying Erie).

17 See In re Huff, 332 B.R. 661, 665 (Bankr. M.D. Ga. 2005). See also Foremost Ins. Co. v. Allstate Ins. Co., 439 Mich. 378, 383-384; 486 N.W.2d 600 (1992); Mackey v. Bristol West Ins. Servs. of Cal., Inc., 105 Cal. App. 4th 1247, 1267 (1st Dist. 2003); Reeves v. Granite State Ins. Co., 36 S.W.3d 58, 60 & n.7 (Tenn. 2001); Gibraltar Fin. Corp. v. Lumbermens Mut. Cas. Co., 400 Mass. 870, 871, 513 N.E.2d 681, 682 (Mass. 1987) (citing J. Appleman, Insurance Law and Practice, Vol. SA, § 3401, at 282 (2d ed. 1970)); Posner v. Firemen's Ins. Co., 49 Ill. App. 2d 209, 199 N.E.2d 44 (1964).

18 Hobbs v. Hartford Ins. Co. of the Midwest, 214 Ill. 2d 11, 17, 823 N.E.2d 561, 564 (2005) ("An insurance policy is a contract, and the general rules governing the interpretation of other types of contracts also govern the interpretation of insurance policies."). See also Hazel Beh & Jeffrey W. Stempel, "Misclassifying the Insurance Policy: The Unforced Errors of Unilateral Contract Characteriza­tion," 32 Cardozo L. Rev. 85, 110 (2010).

19 See In re Huff, 332 B.R. at 665 (explaining the requirements for a lender's rights as loss payee to be recognized under the Bankruptcy Code).

20 Note that the UCC does not factor into the creation or per­fection of a lender's interest in an insurance policy because UCC § 9-l09(d)(8) excludes from the UCC the "transfer of an interest in or an assignment of a claim under a policy of insurance." vee § 9-109(d)(8). See In re JII Liquidating, Inc., 344 B.R. 875, 882 (Bankr. N.D. Ill. 2006) ("[T]he draftsmen [of the UCC] felt that

PROTECTING LENDER INTER ES T IN IN SURANCE PROCEEDS 35

Common Lender Perfection Errors. Nonetheless, lenders frequently fail to prioritize the perfection of their interests in insurance proceeds. Possibly, lenders have an attitude of indifference to perfection because they view the rights arising under their loan agreements with borrowers as sufficient to cure any deficiency. The usual and customary terms of security agreements require borrowers to list lenders as loss payees/mortgagees as the lender's interest may appear. Outside of bankruptcy, lenders that discover that their interest in insurance proceeds is unperfected can rely on their loan agreements to effectively cure their failure to perfect by declaring the borrower in default for breaching the loan agreement.21 Insolvency, however, tests the bounds of the efficacy of this approach to collateral insurance. 22 Borrowers in bankruptcy have often already incurred a payment default (or are at imminent risk of a payment default),

which significantly lessens their concern with respect to non-monetary breaches, concomitantly lessening the prospects for lenders to obtain a recovery from applicable insurance.

The other major error lenders make with respect to perfecting their interest in insurance proceeds is absolute reliance on certificates of insurance. Lenders seeking to confirm that a borrower has complied with the insurance-related terms of a loan agreement are often provided with a certificate of insurance showing the lender as a loss payee/mortgagee. These certificates are often provided by insurance brokers that represent with great certainty that the certificate is sufficient to show the lender has been added as a loss payee or

such transactions are adequately covered by existing law and do not fit within the framework of Article 9.") (citation omitted). See also In re Silver State Helicopters, LLC, 403 B.R. 849, 862 (Bankr. D. Nev. 2009). See also In re QA3 Financial Corp., 2011 WL 1297840, No. BK11...,.80297, at 2-3 (Bankr. D. Neb. Apr. 5, 2011).

21 See Rosario-Paolo, Inc. v. C & M Pizza Restaurant, Inc., 84 N.Y.2d 379, 618 N.Y.S.2d 766, 643 N.E.2d 85 (1994).

22 See, e.g., Corrigan v. U.S. Fire Ins. Co., 427 F. Supp. 940, 942 (S.D. N.Y. 1977) (proceeds not payable to alleged loss payee because policy did not list creditor as such).

mortgagee under the applicable policy. 23 However, in case after case, courts have found that certificates of insurance do not modify insurance policies, and therefore reliance on certificates of insurance to show evidence of a policy modification or addendum is misplaced.24 While it would seem that the common practice of including a clause on the face of these certificates that states that "this certificate does not amend, extend, or alter the coverage afforded by the policies below" would prevent lenders from depend­ing on certificates, there is no shortage of sophisticated parties that have relied on certificates to verify perfec­tion and found their expectations unmet. 25

Although accepting certificates of insurance as evidence that a lender has been added as a loss payee or mortgagee is practical and administratively convenient (and arguably appropriate for short-term verification for funding purposes), a best practice for lenders is to obtain an actual copy of the policy and any endorsements showing the lender as a loss payee or mortgagee, as its interest may appear. The admin­istrative burden of such practices will ultimately be slight compared with the benefit obtained: avoiding costly litigation and unnecessary loss exposure.

DISRUPTION OF LENDER INTEREST A debtor-borrower's bankruptcy can disrupt lender expectations with respect to insurance proceeds, usu­ally in one of two ways. First, bankruptcy provides a forum for the trustee and creditors of the debtor­borrower to expose deficiencies in a lender's claim to have a perfected interest in insurance proceeds. Second, the debtor-borrower may take actions in the

23 See McKenzie v. New Jersey Transit Rail Operations, Inc., 772 F. Supp. 146, 149 (S.D.N.Y. 1991).

24 See Citigroup, Inc. v. Indus. Risk Insurers, 336 F. Supp. 2d 282, 291-292 (S.D.N.Y. 2004) (citing Taylor v. Kinsella, 742 F.2d 709 (2d Cir.1984)); All Crane Rental of Georgia, Inc. v. Vincent, 47 So.3d 1024, 1029-1031 (La. App. 2010). See also Suffolk Const. Co., Inc. v. Illinois Union Ins. Co., 80 Mass. App. Ct. 90, 91 (Mass. App. Ct. 2011); Postl~wait Const., Inc. v. Great Ameri­can Ins. Cos., 106 Wash.2d 96, 99-102, 720 P.2d 805, 806-808 (Wash. 1986) (citing J. Appleman, Insurance, Vol. 13A, § 7530, at 16 (Supp. 1984); Couch on Insurance, Vol. 3, § 40:31 ("[A] certificate of insurance cannot create a contractual relationship between an insurer and an alleged additional insured if the policy itself does not provide for such a relationship.").

25 See Citigroup, 336 F. Supp. 2d at 291-292; All Crane, 47 So.3d at 1029-1031. See, generally, Couch on Insurance, Vol. 2, § 34:24 ("It is critically important for the mortgagee to make sure that the policy of insurance is endorsed to affect the mortgage interest .... Verification of the endorsement should be secured by the mortgagee .... A certificate of insurance would be a general indication that such has been accomplished, but the best evidence is the actual policy or declaration page.").

36 JOURNA L OF TAXAT I ON AND REGU LAT I ON OF FINANC IAL INSTITUTIO NS November/December 201 1 Vol 25 I No 2

bankruptcy case that divest the lender of its right to insurance proceeds pertaining to collateral. The fol­lowing discussion, although by no means a compre­hensive review of the ways bankruptcy can adversely affect lender interest in insurance proceeds, provides context for the bankruptcy-related concerns that lend­ers ought to have and emphasizes the importance of maintaining diligent controls with respect to perfect­ing lender interest in collateral insurance.

Exposing Deficiencies in Perfection. Because one of the core principles underlying the bankruptcy process is equality of distribution, the Bankruptcy Code encourages estate representatives and unsecured creditors to investigate secured creditors' claims of perfection and "test" whether those security interests are, in fact, perfected.26 To facilitate this testing process, the Code provides numerous tools that may be utilized by the trustee (or a creditor, with court permission) to investigate whether a secured creditor has perfected its security interest.27 With respect to a lender's interest in insurance proceeds, the provision that will generally be employed by an estate representative is Section 544 of the Bankruptcy Code.

Section 544 ccstrong Arm'' Powers. Bankruptcy Code Section 544 provides a trustee or Chapter 11 DIP with certain "strong arm" powers to avoid a se­curity interest that is unperfected as of the date of the debtor-borrower's bankruptcy filing.28 When utilized, a security interest that might have been otherwise ef­fective against the debtor-borrower outside of bank­ruptcy is made ineffective against the debtor's other creditors. Thus, after avoidance, the formerly secured creditor will lose its right to a full recovery of what

26 David Hahn, "The Internal Logic of Assumption of Executory Contracts," 13 U. Pa. J. Bus. L. 723, 741 (2011) ("Bankruptcy law's fundamental principle of equality requires equal treatment of all unsecured claims."); Roger A. Clement, Jr., "Going for Broke With Intellectual Property: When Bankruptcy Outcomes Hinge on Licensing Agreements, Executory Contracts, Non-Debtor Parties, and Debtor-in-Possession Issues," 17 Me. B.J. 178, 179 ("fT]he bankruptcy court becomes the crucible in which security interests in property ... are tested.").

27 See 11 U.S.C. § 544, 545, 547, 548, 550, 551. See also Fed. R. Bankr. P. 2004 (permitting the examination of any party in interest to a bankruptcy case and allowing a party to compel the production of documents without some of the constraints imposed by the generally applicable Federal Rules of Civil Procedure).

28 11 U.S.C. § 544. See Carlos J. Cuevas, "Bankruptcy Code § 544(a) and Constructive Trusts: The Trustee's Strong Arm Powers Should Prevail," 21 Seton Hall L. Rev. 678, 683 (1991). See also David W. Skeen, "Liens and Liquidation: Preferences, Strong Arm Clause, Fraudulent Transfers, Equitable Subordination, Priorities and Other Limitations on Liens Claims," 59 Tul. L. Rev. 1401 (1985).

November/December 2011 Vol 25 1 No 2

it believed was a secured claim, and will be forced to share pro rata in any distribution provided to general unsecured creditors.29

The trustee's strong arm powers are tied to state law, meaning that the extent of a trustee's rights vis-a­vis a commercial lender will vary from state to state.30

In the worst-case scenario for the lender, however, applicable state law will construe insurance proceeds as a personal right of the debtor-borrower, meant to compensate the borrower for losses that it may incur. 31

Under this interpretation of insurance, the proceeds of a policy do not "flow from the property. "32

What this means for a lender is that the provision in the security agreement that purports to entitle it to insurance proceeds relating to insured collateral may be held to be of no effect if the actual insur­ance policy does not list the lender as a loss payee or mortgagee. 33 Courts that follow this rationale generally focus on the fact that an insurance policy is a contract that must be enforced according to its terms; therefore, if the lender is not listed in the policy, it has no direct right to policy proceeds. Under this construction, the omission of the lender from the policy results in the insurance proceeds being payable to the only party actually listed in the policy-i.e., the debtor-borrower. 34 Since the debtor-borrower is in bankruptcy, this right to proceeds belongs to the bankruptcy estate. Accordingly, any money paid by the insurance company will be placed in the general pool of estate proceeds and distributed pursuant to the Bankruptcy Code's priority scheme. 35

Lenders' Defense vs. Section 544. Through litiga­tion, some financial institutions have prevented the disastrous result of complete divestiture of their right to insurance proceeds. Primarily, this has been ac­complished by advancing an "equitable lien" theory: the lenders take the position that, because they were promised a lien on insurance proceeds relating to their

29 11 U.S.C. §§ 506, 726, 1129(a)(7).

30 11 u.s.c. § 544(b)(1). 31 Am. Bankers Ins. Co. of Fla. v. Maness, 101 F.3d 358,

365-366 (4th Cir. 1996) (applying Virginia law, indicating that "payments made pursuant to insurance contracts protecting against damage to property are not proceeds derived from the property itself"). Cf. Ford Motor Credit Co. v. Feher (In re Feher), 202 B.R. 966, 970 (Bankr. S.D. Ill. 1996).

32 Id. 33 Hovis v. New Hampshire Ins. Co. (In re Larymore), 82 B.R.

409, 414-415 (Bankr. D. S.C. 1987). 34 See In re Whitacre, 1976 WL 23675, Nos. B-376-359 and

B-376-360 (S.D. Ohio Sept. 23, 1976). See also In re Levine, 1969 WL 10996, No. 33,123 (D. Conn. Jan. 17, 1969).

35 11 u.s.c. § 726.

PROTECT ING LENDER INTER ES T IN INSURA NCE PROCEEDS 37

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collateral, the bankruptcy court should afford them one.36 Although this theory has been successful on oc­casion, it has a significant flaw: It forces the lender, a sophisticated supplier of financial products, to take the position that it relied-and had to rely-upon the borrower to ensure the lender was made a loss payee or mortgagee under the applicable insurance policy. Given that it is obviously possible for the lender to take steps to verify its loss payee/mortgagee status, a court could easily find such reliance misplaced, and decline to grant an equitable lien. In any case, the litigation costs of dealing with the lack of perfection greatly outweigh the costs of ensuring perfection. The better approach by far is simply to institute appro­priate controls, targeted at verifying that the lender's interest in applicable insurance is properly perfected, in the first place.

Divesting the Lender of its Interest. In addition to exposing defects in perfection, bankruptcy can result in the divestiture of a lender's interest in insurance

proceeds under certain circumstances. One of the primary examples of how a lender's perfected interest in insurance proceeds can be disrupted arises when a debtor-borrower transfers property during a Chapter 11 case, which can occur either when the debtor is reorganizing or when the debtor is selling its assets under Bankruptcy Code Section 363 .37

The Insurance Policy as an ccExecutory Contract.,, When a debtor-borrower files bankruptcy, its ability to deal with its pre-bankruptcy contracts may be altered, depending on whether those contracts are "execu­tory" or "non-executory."38 One of the most confused and misunderstood insurance-related concepts that is dealt with in bankruptcy is when and whether an in­surance policy is an "executory contract." Financial institutions need to be aware of this issue because debtors that are transferring the title to property in the course of their bankruptcy case will often repre-

36 See United States v. Wilson (In re Wilson), 269 B.R. 829, 837 (Bankr. D. N.D. 2001). See also In re Coker, 216 B.R. 843, 852-856 (Bankr. N.D. Ala. 1997).

37 11 U.S.C. §§ 363, 1123(a)(5). 38 11 u.s.c. § 365.

sent that lender collateral remains fully insured at all times-before and after the transfer-on account of the debtor's treatment of its insurance policies as ex­ecutory contracts. Where the debtor is mistaken about the nature of its purportedly executory insurance poli­cies, the lender may find that its collateral has become uninsured.

Executory Contracts, Generally. In bankruptcy cases, contracts to which the debtor is a party are di­vided into two groups: executory and non-executory. Contracts are executory if })oth parties owe perfor­mance. More specifically, "~n executory contract is a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach ex­cusing the performance of the other. "39

If a contract is executory, the debtor has a choice: ( 1) it may assume the benefits and obligations of the contract (if certain requirements are met), or (2) it may reject the contract, leaving the counter-party with just a general unsecured claim in the bankruptcy case.40

Conversely, if a contract is not executory, there is no choice for the debtor to make-the contract simply represents a binding obligation that rides through the bankruptcy case.41 In no case may the debtor modify the terms of the contract.

Treatment of Insurance Policies. Frequently, Chapter 11 debtors reorganize by transferring their

39 In reGen. DataComm Indus., Inc., 407 F.3d 616, 623 (3d Cir. 2005) (internal quotations and citation omitted). See also N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513, 522 n.6 (1984); Vern Countryman, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L. Rev. 439, 460 (1973). See generally Michael T. Andrew, "Executory Contracts in Bankruptcy: Understanding Rejection," 59 U. Colo. L. Rev. 845 (1988) (executory contract means "sim­ply a contract under which (a) debtor and non-debtor each have unperformed obligations and (b) the debtor, if it ceases further performance, would have no right to the other party's continued performance"); H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 347 (1977) ("Though there is no precise definition of what contracts are executory, it generally includes contracts on which performance remains due to some extent on both sides.").

40 11 U.S.C. § 365(a). See L.R.S.C. Co. v. Rickel Home Centers, Inc. (In re Rickel Home Centers, Inc.), 209 F.3d 291, 298-299 (3d Cir. 2000).

41 See Hays & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 885 F.2d 1149, 1153 (3d Cir.1989). See also In re Exide Techs., 378 B.R. 762, 765 (Bankr. D. Del. 2007); Stumpf v. McGee (In re O'Connor), 258 F.3d 392, 405 (5th Cir. 2001) ("[T]here is no difference between a contract that ... cannot be assumed, and one which is neither assumed nor rejected .... Each is simply unaffected by the bankruptcy proceedings.").

38 JOURNAL OF TAXAT ION AND REGULATION OF FINANCIA L INS TITUT IONS November/December 2011 Vol 25 I No 2

assets-either through a sale42 or under a plan of reor­ganization43-to a new entity. Because the new entity will take title to the debtor's assets when the transaction closes, the debtor-transferor's "insurable interest" in the assets will terminate and the new entity will gain an insurable interest. A lender's interest in the property as a secured creditor would generally transfer contempo­raneously with the transfer of title, and the lender will accordingly obtain an insurable interest in the property, as titled under the name of the new entity/owner, as a result of the transfer.44 To maintain continuous insur­ance coverage, the transferring instruments often pro­vide that the debtor-borrower's insurance policies are "deemed" to be executory contracts, and that, as per­mitted by Bankruptcy Code Section 365, the executory insurance policies are "assumed" and "assigned" to the transferee entity.45 Stated simply, the transfer docu­ments allege that the insurance follows the title.

The problem with "deeming" insurance policies to be executory contracts, however, is that the Bankruptcy Code does not permit a debtor to change the execu­tory nature of a contract by decree.46 A contract is either "executory" or it is not. As indicated, to make this determination, courts examine whether there are

42 Bankruptcy Code§ 363 permits debtors to sell their assets to a new entity without using a plan of reorganization. 11 U.S.C. § 363(b). In recent years, this has become a common way for busi­nesses to use Chapter 11 to "cleanse" assets of all liabilities and continue business operations. See Brad B. Erens & David A. Hall, "Secured Lender Rights in 363 Sales and Related Issues of Lender Consent," 18 Am. Bankr. Inst. L. Rev. 535, 535 (2010).

43 11 U.S.C. § 1123(a)(5) ("[A] plan shall ... (5) provide adequate means for the plan's implementation, such as ... (B) 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; [or] ... (D) sale of all or any part of the property of the estate, either subject to or free of any lien, or the distribution of all or any part of the property of the estate among those having an interest in such property of the estate.").

44 This assumes, of course, that the property is being transferred subject to the lender's interest. Whether transferring property under a plan of reorganization or by sale under § 363, debtors frequently have no choice but to allow first position lenders to retain their liens on collateral, given the secured creditor's right to prevent confirmation or credit bid, as the case may be, and thereby prevent the transfer. See 11 U.S.C. § 1123(b) ("[A] plan may ... (3) provide for ... (5) leave unaffected the rights of holders of any class of claims); 11 U.S.C. § 1129(a)(7), (8); 11 U.S.C. § 363(b), (f).

45 See, e.g., In reSource Interlink Cos., Inc., 2009 WL 7768692, No. 09-11424 (Bankr. D. Del. May 28, 2009). See also In re Armstrong World Indus., Inc., 348 B.R. 136 (D. Del. 2006); In re Stations Holding Co., Inc., 2002 WL 31947022, No. 02-10882 (Bankr. D. Del. Sept. 30, 2002); In re Citadel Broad. Corp., 2010 WL 2010808, No. 09-17442 (Bankr. S.D.N.Y. May 19, 2010); In reT H Agri. & Nutrition, LLC, 2009 WL 7193573, 08-14692 (Bankr. S.D.N.Y. May 28, 2009).

46 See In re Exide Techs., 378 B.R. at 766-767 ("Plan language cannot 'deem' a non-executory contract to be an executory contract so that the Debtor can assume it.").

November!OeGem ber 2011 Vol 25 / No 2

material unperformed obligations owed by each party to the contract. Accordingly, contracts that have expired according to their terms are not executory, as are con­tracts where one party has completely performed.47

With these requirements in mind, courts have found that an insurance policy constitutes an execu­tory contract if two criteria are met:

1. The insurance policy must be in force, meaning that the current policy period must not have expired, and the policy must not have been cancelled.48

2. There must be unpaid premiums due to the insurer.49

The second criteria is often absent in Chapter 11 cases, given the tendency of policyholders to pay their entire premium at policy inception.50 If an insurance policy is not executory, an attempt to deem it executory is void, and the policy does not transfer automatically to the new entity. 51 If a transfer of insurance is to occur,

47 See Counties Contracting and Canst. Co. v. Canst. Life Ins. Co., 855 F.2d 1054, 1061 (3d Cir. 1988) ("A contract may not be assumed under § 365 if it has already expired according to its terms.") (citing Collier on Bankruptcy, Vol. 2, <JI 365.04). See also In re Balco Equities Ltd., Inc., 312 B.R. 734, 750 (Bankr. S.D.N.Y. 2004) ("If a contract has expired by its own terms then there is nothing left to assume or reject.") (quoting In re Texscan Corp., 107 B.R. 227, 230 (B.A.P. 9th Cir. 1989)).

48 Am. Safety Indem. Co. v. Vanderveer Estates Holding, LLC (In re Vanderveer Estates Holding, LLC), 328 B.R. 18, 26 (Bankr. E.D.N.Y. 2005) ("It is well established that insurance policies for which the policy periods have expired ... are not executory contracts, despite continuing obligations on the part of the insured.").

49 See Admiral Ins. Co. v. Grace Indus., Inc. (In re Grace Indus., Inc.), 341 B.R. 399,403 (Bankr. E.D.N.Y. 2006) ("Where, as in this case, an insured debtor has paid the initial premium in full, and the policy period has expired, the insurance policy is not an executory contract, despite continuing obligations on the part of the insured."). See also Firearms Import & Export Corp. v. United Capitol Ins. Co. (In re Firearms Import and Export Corp.), 131 B.R. 1009, 1012-1015 (Bankr. S.D. Fla. 1991) ("[T]he sole basisfor holding an insurance policy to be an executory contract-the continuing obligation of the debtor to make premium payments-is lacking in this case."); Columbia Cas. Co. v. Fed. Press Co., Inc. (In re Fed. Press Co., Inc.), 104 B.R. 56, 65-66 (Bankr. N.D. Ind. 1989) (citing Collier on Bankruptcy, Vol. 2, <JI 365.02 (15th ed. 1988)).

50 The fact that a policy is financed through a premium finance company will not save it from being "non-executory," since, from the insurance company's perspective, no material obligations are owed by the insured.

51 Claims arising prior to the transfer of the property will not be affected by the transfer. As a general rule, bankruptcy does not affect the liabilities of parties other than the debtor. 11 U.S.C. § 524(e) ("[D]ischarge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt."). See generally Susan N.K. Gummow & John M. Wunderlich, "Suing the Debtor: Examining Post-Discharge Suits Against the Debtor," 83 Am. Bankr. L.J. 495, 495-496 (2009). Thus, transfer of an asset or discharge of the former owner will not obviate the liability of an insurer.

PROTECT ING LENDER INTE REST IN IN SURANC E PROCE EDS 39

it will be through the insurer's. agreement to insure the new entity, and not by operation of bankruptcy law.

Protection of Lenders' Interests. As complex as the issue of treating insurance policies as "executory con­tracts" is, ensuring that lender expectations are not disrupted by the transfer of insured collateral to a new entity is not difficult. Financial institutions must merely require affirmative consent and acknowledgement from the collateral insurer that the property, as titled in the name of the new entity/owner, is insured. Although the debtor-borrower's counsel is likely to balk at the need for verification, lenders are likely to find insurers are amenable to providing such consent and acknowledge-

ment. Moreover, financial institutions will many times find that their request for consent and acknowledge­ment of insurance is the first notice the insurer has of the bankruptcy process and of the debtor-borrower's attempt to transfer insurance to a new entity. In such a case, the financial institution has probably saved itself a great deal of trouble and expense by straightening out these insurance issues prior to any asset transfer.

UCC CONSIDERATIONS FOR LENDERS When borrowers facing insolvency attempt workouts or restructuring processes outside of bankruptcy, fi­nancial institutions will occasionally be faced with vee issues relating to their interest in insurance pro­ceeds. These issues are rare because the vee does not generally apply to interests in insurance proceeds or policies. 52 However, there are two primary exceptions. Section 1-109(d) of the vee provides that although Article 9 (the vee article that deals with secured transactions) does not apply to "(8) a transfer of an interest in or an assignment of a claim under a policy of insurance, ... Sections 9-315 and 9-322 apply with respect to proceeds and priorities in proceeds." 53

52 As a caveat, some courts find that the vee can apply to insurance proceeds under certain circumstances, but that is beyond the scope of the issue of lender perfection that is the focus of this article.

53 vee§ 9-109 (2010).

The two exceptions to the vee's insurance exclusion-Vee Sections 9-315 and 9-322-concern the relationship between the state law perfection requirements applicable to insurance proceeds (i.e., whether the policy identifies the lender as a loss payee/mortgagee, and complies with any other state law requirements), and the perfection requirements of Article 9.

UCC Section 9-315. As applied to a lender's interest in the proceeds of an insurance policy, vee Section 9-315 indicates that if a lender holds a perfected interest in the proceeds of an insurance policy, Article 9 will recognize that interest and prevent unsecured creditors from acquiring any senior interest in funds received on account of the insurance claim. 54 In essence, the vee transfers the lender's perfection in the policy to the cash proceeds received on account of a claim. If cash proceeds received on account of the claim are segregated, perfection continues indefinitely. 55 Otherwise, a lender must perfect its interest in the cash proceeds within 21 days, pursuant to the generally applicable requirements of article 9.56

UCC Section 9-322. vee Section 9-322 governs the priority of competing security interests that are perfected. As applied to insurance proceeds, it provides that a lender with a perfected interest in proceeds has priority over all creditors that have unperfected competing security interests, as well as all creditors that perfected their interest later in time than the lender.57 To the extent that there are competing perfected security interests, Vee Section 9-322 provides that the lender's time of perfection in cash proceeds that are received relates back to the time of initial perfection in the insurance policy. 58

54 vee§ 9-315 (2010) provides, in part:

(a) ... (1) [A] security interest ... continues in collateral notwithstanding sale, lease, license, exchange, or other disposition thereof unless the secured party authorized the disposition free of the security interest or agricultural lien; and (2) a security interest attaches to any identifi­able proceeds of collateral. ...

(c) [Perfection of security interest in proceeds.] A security interest in proceeds is a perfected security interest if the security interest in the original collateral was perfected.

vee§ 9-315 (2010). 55 vee § 9-315(d) (2010) ("A perfected security interest i~

proceeds becomes unperfected on the 21st day after the security interest attaches to the proceeds unless ... the proceeds are iden­tifiable cash proceeds.").

56 vee§ 9-315(e) (2010). 57 vee§ 9-322(a) (2010). 58 vee§ 9-322(b) (2010).

40 JOURNA L OF TAXATION AND REGULATIO N OF FINANC IAL INST ITUTION S November/Dece mber 2011 Vol 25 I No 2

Lender Precautions. In the ordinary case where a commercial lender receives payment on account of its interest in an insurance policy, the lender generally should not find itself subject to competing claims as a consequence of these UCC provisions. However, in a more complex situation, such as where cash proceeds received on account of a claim are held by a third party, or where the financial institution's collateral is related to an unusual lending facility, lenders should be cognizant of the fact their security interest in proceeds received on account of an insurance claim may expire 21 days after receipt unless the lender perfects its interest pursuant to Article 9. 59 In many cases, this will mean executing or amending a security agreement and filing a financing statement with the appropriate state office.60

59 ucc § 9-315 (2010); ucc § 9-322 (2010). 60 See Helms v. Certified Packaging Corp., 551 F.3d 675, 679

(7th Cir. 2008) (discussing the requirements for perfection under Article 9).

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CONCLUSION Lender expectations can be severely disrupted by the failure to give appropriate attention to perfecting interests in insurance proceeds. It is vital that com­mercial lenders and other financial institutions act to prevent the impairment of their interests by imple­menting effective controls to verify perfection at the earliest commercially reasonable point in time. This goes beyond reliance on certificates of insurance or loan agreement provisions,-and requires that lenders retain copies of insurance policies pertaining to their collateral. Lenders must verify that they are the named loss payee or mortgagee, as applicable, under any pol­icy insuring their collateral, and must verify that all other state law requirements for perfection are met. Through diligent attention to their obligations, lend­ers can avoid the impairment of their interests when their borrowers face insolvency, whether that insol­vency implicates provisions of the Bankruptcy Code or the UCC. •

PROTEC TI NG LEND ER INTE REST IN I NSURA NCE PROCEEDS 41