Federal-Mogul Court Confirms That Bankruptcy Law Trumps Anti-Assignment Provisions in Insurance Policies

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[authors: Christopher J. Updike]

On May 1, 2012, the United States Court of Appeals for the Third Circuit in In re Federal–Mogul Global, Inc. confirmed that anti-assignment provisions in a debtor’s insurance liability policies are preempted by the Bankruptcy Code to the extent they prohibit the transfer of a debtor’s rights under such policies to a personal-injury trust pursuant to a chapter 11 plan. In re Federal-Mogul Global Inc., — F.3d —, 2012 WL 1511773 (3d Cir. 2012). In so holding, the Third Circuit follows its prior dicta as well as the precedent of its sister circuits, and provides its most definitive ruling on the issue to date.

Preemption of Anti-Assignment Provisions

It is a well-established principle that the Supremacy Clause of the Constitution invalidates state laws that “interfere with, or are contrary to, federal law.” State law may be preempted “by express language in a congressional enactment, by implication from the depth and breadth of a congressional scheme that occupies the legislative field, or by implication because of conflict with a congressional enactment.” Pursuant to this precedent, the Fourth and Ninth Circuit Courts of Appeals have held that section 1123(a)(5)(B) of the Bankruptcy Code preempts anti-assignment provisions in insurance policies that prohibit a debtor from assigning its rights under such policies to third-parties pursuant to a chapter 11 plan. See Pac. Gas & Elec. Co. v. Cal. ex rel. Cal. Dep’t of Toxic Substances Control, 350 F.3d 932, 946 (9th Cir. 2003); In re FCX, Inc., 853 F.2d 1149, 1154-55 (4th Cir. 1988).

Section 1123(a)(5)(B) provides that “[n]otwithstanding any otherwise applicable nonbankrutpcy law, a plan shall . . . provide adequate means for the plan’s implementation, such as . . . 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.” The congressional intent behind a “notwithstanding” clause, which prefaces numerous sections in the Bankruptcy Code, has been interpreted as express preemption. Other support for preemption of anti-assignment provisions comes from section 541(c)(1) of the Bankruptcy Code, which provides that “an interest of the debtor in property becomes property of the estate . . . notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law — (A) that restricts or conditions the transfer of such interest by the debtor.”

The Third Circuit has addressed this issue twice before in dicta, coincidentally in the 27th footnote of each decision. In Combustion Engineering, the court stated that a combination of sections 1123(a)(5)(B) and 541(c)(1) effectively preempts any contractual provision that purports to limit or restrict the rights of a debtor to transfer or assign its interests under insurance policies. In re Combustion Eng’g, Inc., 391 F.3d 190, 218 n.27 (3d Cir. 2004). However, the court refrained from actually deciding the issue because it vacated the plan being considered on other grounds. More recently, the Third Circuit sitting en banc in In re Global Industrial Technologies, Inc. noted that “the discussion of anti-assignment provisions in Combustion Engineering should suffice” to resolve whether insurance policies could be transferred. In re Global Indus. Techs., 645 F.3d 201, 212 n.27 (3d Cir. 2001), cert. denied, 132 S.Ct. 551 (2011) Again, the court didn’t address the issue because it remanded the district court’s decision on standing grounds.

Background

Federal-Mogul Global, Inc., one of the world’s largest manufacturers of automobile parts, filed for chapter 11 bankruptcy protection in October of 2001, primarily to resolve hundreds of thousands of personal injury claims related to asbestos liability. The debtors proposed a plan of reorganization that sought an injunction under 11 U.S.C. § 524(g) to channel present and future asbestos-related claims to a post-confirmation trust.

Among other assets, the debtors in Federal-Mogul sought to assign their rights to recovery under certain liability insurance policies to the trust for asbestos claimants. Under the plan, insurance providers would still be able to assert any defense to coverage that was originally available under the policies. Despite this, certain insurers objected to confirmation of the plan, arguing that the plan violated anti-assignment clauses in the liability policies (which are generally standard in such agreements) that prohibit the insured party from transferring the policy without the insurer’s consent. In response, the debtors argued that section 1123(a)(5)(B) preempted the anti-assignment provisions of the insurance policies.

On March 19, 2008, Bankruptcy Judge Judith Fitzgerald ruled that the debtors’ insurance policies were assets of the estate pursuant to section 541 of the Bankruptcy Code and section 1123(a)(5) did indeed allow the transfer of this property to the section 524(g) trust. The bankruptcy court’s ruling acknowledged the state insurance law doctrine that assignment of rights to insurance proceeds after the occurrence of the event giving rise to liability under the policy does not violate anti-assignment provisions because the assignment does not pose any additional risk to the insurance company – the reasoning being that if the event giving rise to the insurer’s liability have already occurred, the risk and potential liability will not be increased by a change in the insured’s identity.

On appeal, the district court found that the “notwithstanding” clause in section 1123(a) was evidence of a clear congressional intent to preempt conflicting state law. In addition, the district court noted that allowing the debtors to assign the insurance policies was consistent with public policy – without such an assignment, neither the debtors nor the asbestos claimants would have access to the insurance proceeds and the insurance companies would receive a windfall. Accordingly, the district court affirmed the bankruptcy court’s ruling.  Certain insurers appealed to the Third Circuit.

Third Circuit’s Decision

The Third Circuit followed the Fourth and Ninth Circuits in finding that section 1123 preempted the anti-assignment provisions of the insurance policies. The Court based its analysis first and foremost on the plain language of the statute, noting that the words “Notwithstanding any otherwise applicable non-bankruptcy law . . .”, which were added to the statute in 1984, are clear evidence of Congress’ express intent that the statute should override conflicting state statutes. The insurers argued that the language should not be read to apply to subsection (A) through (J) of section 1123(a)(5) or to encompass private contracts. The court dismissed each argument, holding that the former was an unnatural reading of the statute which “contravenes any normal method of statutory interpretation,” and the latter was unsupportable based on the strength of the statutory language and precedent from the Supreme Court and Fourth Circuit.

The Court next turned to the context and structure of the Bankruptcy Code, which the insurers said supported a narrow reading of preemption. Specifically, the insurers argued that a broad reading of section 1123(a) would be inconsistent with section 1142, which provides for the execution of a plan “[n]otwithstanding any otherwise applicable nonbankruptcy law . . . relating to financial condition.” These two statutes, they argued, must be read in pari materia (i.e., the sections must be interpreted in light of each other since they deal with the same subject matter). The Third Circuit disagreed and cited the principle of statutory interpretation that where Congress has inserted limiting words in only one of two related provisions, courts must presume that the inclusion and exclusion was intentional. Further, section 1123 was amended to include the limiting language after enactment of section 1142, and thus, the Court assumed that Congress was aware of the preemptive language of section 1142 when it amended section 1123.

The insurers also urged that a narrow reading of section 1123(a) based on pre-Code practice and legislative history. Specifically, the insurers alleged that prior to passage of the 1978 Bankruptcy Code, courts generally required plans of reorganization to comply with state law, and that because the legislative history is relatively silent about why section 1123 was amended in 1984, the Court should presume that Congress did not intend to depart from such practice. In response, the Court noted that pre-Code practice was not the law when section 1123 was amended; the 1978 Code was, which substantially altered earlier practice. Further, case law between 1978 and 1984 generally held that section 1123 preempted state law. Ultimately, the Court declined to rely on prior practice or “thin and vague legislative history” where the preemptive language of section 1123(a) was plain and unambiguous.

Lastly, the Third Circuit emphasized that preemption furthers the purposes of the Bankruptcy Code.  Assignment of the debtors’ rights under the insurance policies to the section 524(g) trust enables them to receive the “fresh start” that the Bankruptcy Code aims to give all chapter 11 debtors, and the proceeds from the insurance policies are still available to compensate alleged victims for their losses as contemplated under the policies. Conversely, enforcing the anti-assignment provisions would lead to a windfall for insurance companies because neither the debtor nor the claimants could access the proceeds of the policies.

Despite its ruling, the Third Circuit cautioned that the scope of preemption of section 1123(a) of the Bankruptcy Code is not unlimited. Any plan of reorganization must still comply with all relevant sections of the Bankruptcy Code. Further, there is a longstanding presumption against preemption of state police power laws or regulations rooted in “federalism concerns and the historic primacy of state regulation of matters of health and safety.”

Conclusion

The Third Circuit’s decision in Federal-Mogul confirms that the assignment of insurance policies to a creditor trust is permissible. This is significant because debtors often assign their rights under insurance policies to such trusts, whether pursuant to a direct transfer of their rights to recover under the policy or a “buy back” of the policy and a transfer of the proceeds of such sale to the trust. While disputes over the precise boundary of section 1123(a)’s preemptive power may continue, Federal-Mogul solidifies the legal authority behind a well-established practice in today’s bankruptcy community.

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