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By G. Brian Odom and Jennifer L. Gibbs
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Navigating the foreclosure and/or bankruptcy process while adjusting or litigating a first-party property insurance claim can cause significant complications for insurance carriers and the attorneys who represent them. Below is a list of issues to be aware of and consider when the insured is in financial straits.

1. Insurable Interest

The simple question of “who had an insurable interest at the time of the loss” is typically a straightforward element of an insurance coverage dispute. When the insured is facing foreclosure or bankruptcy, however, this simple concept can become less clear.

The general rule adopted by most jurisdictions is that any person or entity has an insurable interest in property if that person or entity derives a benefit from its existence or would suffer a pecuniary loss from its destruction.[1]

For example, both a mortgagor and mortgagee can have independent insurable interests if the property is subject to a mortgage. When a loss occurs after the mortgagee has foreclosed on the property, the mortgagee is essentially the owner of the property and has an insurable interest.

The mortgagee’s rights under an insurance policy are terminated if, after a loss, the underlying debt is satisfied by a purchaser at a foreclosure sale. To the extent a deficiency exists after the foreclosure and sale, the debt remains, and the mortgagee may maintain an insurable interest until the debt is satisfied.[2]

In a bankruptcy situation, if a property policy has lapsed or is close to expiration, the receiver must purchase insurance to protect the property. Although the receiver has authority to obtain the insurance, there are conflicting court opinions as to whether the receiver has an insurable interest or merely the authority to take action on behalf of the parties who will ultimately benefit from the insurance.[3]

When adjusting a loss, one should be aware of competing claims to policy proceeds by the property owner, mortgagee, receiver and/or trustee, all who may have an insurable interest in the insured location.

2. The Interplay Between Policy Language and Mortgage Documents

Policies typically contain language naming a mortgage holder as a loss payee “as their interest may appear.” However, many mortgages or deeds of trust require a policyholder to assign all insurance proceeds and all causes of action, claims, compensation, awards or recoveries to the lender, including business income losses and even extra-contractual claims.

Despite this broad language, insurers should be aware that under certain state statutes, the assignment of claims which involves a “consumer” may be prohibited. Thus, one should examine the precise language of the loss payable provision and ascertain whether the policy language specifically incorporates the contractual mandates of the mortgage or deed of trust and whether such language is valid and enforceable under the applicable state laws.

3. Notice of Foreclosure by Bank

A property insurance carrier may be unaware that a lender is planning to foreclose on insured property and the insured and/or its lender may not provide the insurer with notice. A question then arises as to whether the insured’s receipt of such notice constitutes a material or substantial increase in risk requiring the insurer to be notified, and perhaps providing the insurer with grounds to increase the premium or cancel the policy altogether.

The majority of courts that have addressed this issue have held that foreclosure proceedings do not create an incentive to destroy property constituting a substantial change of risk.[4] Thus, an insurer may wish to include policy language specifically requiring adequate notice of the commencement of foreclosure proceedings to fully protect its rights.

4. The Mechanics of Judicial and Nonjudicial Foreclosures

Insurance carriers and their lawyers should be aware of the mechanics of judicial and nonjudicial sales in the applicable jurisdiction.

The judicial process of foreclosure, which involves filing a lawsuit to obtain a court order to foreclose, is used when no power of sale is present in the mortgage or deed of trust.

The nonjudicial process of foreclosure is used when a power of sale clause exists in a mortgage or deed of trust and permits the mortgage holder to sell the property to pay off the balance on a loan in the event of default.

One should be aware that some jurisdictions permit only judicial sales, while others permit both judicial and nonjudicial foreclosures. Additionally, in at least one state, judicial sales transfer ownership instantaneously, while other states require a waiting period before the buyer assumes rightful title to the property.

Should a loss occur during this waiting period, the insurer should be aware of who has an insurable interest at the time of the loss and what insurance policies may respond to cover the property damage.

5. Business Income Recovery Post-Foreclosure

An interesting issue arises when the insured is divested of its ownership via foreclosure following a loss but carried insurance for lost business income at the time of the loss. Is the insured entitled to recover its lost business income post-foreclosure, assuming foreclosure occurred during the period of restoration?

Those in favor of permitting the insured to recover its lost business income even after a change in ownership would argue that the insurer would have paid full policy proceeds during the period of restoration absent foreclosure and the insurer should not be entitled to limit payment merely because ownership transferred post-loss.[5]

However, specific policy language may limit recovery to “actual loss sustained” and insurers have relied on that language to cease their obligation to make payments for time element claims after title has passed.[6]

Depending on the policy language and the case law of the particular jurisdiction involved, the fact that the insured has lost ownership of the property either through foreclosure or sale may not automatically relieve the insurer from its obligation to pay lost business income.

6. Recovery of Replacement Cost Proceeds

If the insured makes some repairs resulting from a covered cause of loss, but those repair expenditures do not exceed the actual cash value payment, an interesting coverage issue arises as to whether the insured is entitled to recover replacement cost proceeds if the property is lost in foreclosure and it is a practical impossibility for the insured to complete the repairs.

There is a notable absence of case law on this issue. However, insurers should be aware that some courts do not require actual replacement as a condition to recovery of replacement cost proceeds, rationalizing that without the necessary funds being advanced by defendant, the insured would have little likelihood of being able to secure financing to repair or replace its property.[7]

Other courts do require actual replacement, stating that “to permit an insured to receive the full repair/replacement cost proceeds without actually effecting the repairs would give the insured a greater windfall than the parties contemplated and the insured paid for.”[8]

An insurer should carefully examine the language of its replacement cost provision and the case law of the applicable jurisdiction in evaluating whether the insured may be entitled to recover replacement cost proceeds even if the insured can no longer make the repairs because it no longer owns the property.

7. Property Insurance Proceeds are Almost Always Property of the Estate

Casualty, collision, life and fire insurance policies in which the debtor is a beneficiary are almost always considered property of the estate in bankruptcy.[9] Even if a particular policy qualifies as property of the estate, however, the policy proceeds may not.[10]

The central question courts employ in deciding whether insurance proceeds associated with a policy are “property of the estate” is whether, in the absence of a bankruptcy proceeding, proceeds would belong to the debtor when the insurer pays on a claim.[11] In the first-party property context, policy proceeds are generally property of the estate.

8. Vacancy Provision

If a receiver has been appointed and a property policy has lapsed or is close to expiration, the receiver must purchase insurance to protect the property. In that scenario, the property may be unoccupied or vacant at the time of policy inception.

Despite the existence of a valid vacancy provision that might otherwise preclude or limit coverage, insurers should be aware that courts have interpreted policy provisions stating that a lender will not to be jeopardized by acts or omissions of an owner in holding that the mortgagee was protected under the policy even if the mortgagee knew the property was vacant due to foreclosure.[12]

Moreover, if the insurer or its agent was aware of the vacancy at the time of policy issuance, the insurer may be held to have waived the right to rely on an otherwise enforceable vacancy provision.[13]

9. Bankruptcy’s Impact on Litigation

The Bankruptcy Code provides that upon the filing of a bankruptcy petition, all litigation, lien enforcement and other actions, judicial and nonjudicial, in which a third party attempts to enforce or collect pre-petition claims are prohibited.[14]

An insurance carrier seeking to resolve a coverage dispute may be precluded from filing a declaratory judgment action, as this prohibition is broad enough to bar all judicial proceedings against the debtor, including declaratory judgment actions.[15] A carrier must be given express permission by the bankruptcy court to pursue its declaratory judgment action.[16]

Moreover, an insurer may be required to litigate all coverage issues in bankruptcy court. By understanding these provisions of the Bankruptcy Code, counsel for an insurer will ensure that the actions are filed appropriately, ultimately saving their client time and expense.

10. Settlement Must be Approved by Trustee

Once a settlement is reached with an insured in bankruptcy, an insurer must abide by the requirements of the Bankruptcy Code, or risk that the settlement will be unenforceable.

First, the insurer must seek approval by the bankruptcy court. For a settlement to be approved, interested parties must receive notice and have an opportunity to object.[17]

In determining whether to approve a settlement, bankruptcy courts will consider whether a settlement is in the best interest of the estate. An insurer also should be aware that the trustee might refuse to approve standard settlement agreement language providing indemnification for claims brought against the insurer because the insured entity may no longer legally exist after bankruptcy, rendering the indemnification language illusory or unenforceable.

Additionally, the trustee may view a requirement of indemnification as potentially hindering resolution of the bankruptcy estate.

--By G. Brian Odom and Jennifer L. Gibbs, Zelle Hofmann Voelbel & Mason LLP

Brian Odom is a partner and Jennifer Gibbs is an associate in Zelle Hofmann’s Dallas office.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] 3 COUCH ON INSURANCE § 41:11 (2011).

[2] See Builders Affiliates, Inc. v. N. River Ins. Co., 91 A.D.2d 360, 363 (1983).

[3] Cabaud v. Federal Ins. Co., 37 F.2d 23, 34 (S.D.N.Y. 2d Cir. 1930); Dallas Bank & Trust Co. v. Thompson, 87 S.W.2d 307, 308 (Tex. Civ. App.—Dallas 1935, no writ).

[4] See, e.g., U.S. Bank v. Tenn. Farmers Mut. Ins. Co., 277 S.W.3d 381, 390 (Tenn. 2009).

[5] See, e.g., SR Inter. Bus. Ins. Co., Ltd. v. World Trade Ctr. Properties, LLC, 375 F. Supp. 2d 238, 249 (S.D.N.Y. 2005).

[6] See, e.g., B A Properties, Inc. v. Aetna Casualty & Surety Co., 273 F.Supp.2d 673, 683-84 (D.V.I. 2003).

[7] See Zaitchick v. American Motorists Ins. Co., 554 F.Supp. 209, 217 (S.D.N.Y. 1982).

[8] Travelers Indemnity Co. v. Armstrong, 442 N.E.2d 349, 353 (Ind. 1982).

[9] Matter of Edgeworth, 993 F.2d 51, 56 (5th Cir. 1993).

[10] Proceeds of a liability policy are typically not property of the estate because the debtor has no cognizable interest in those proceeds. See Edgeworth, 933 F2d at 56.

[11] See In re Hereford Biofuels, L.P., 466 B.R. 841, 856-57 (Bankr. N.D. Tex. 2012).

[12] Roosevelt Sav. Bank v. State Farm Fire & Casualty Co., 556 P2d 823 (Ariz. App. 1976).

[13] See, e.g., Marketfare Canal, LLC v. United Fire & Cas. Co., 594 F. Supp.2d 724, 732 (E.D. La. 2009).

[14] 11 USC §362 (2012).

[15] See In re Johns-Manville Corp., 31 B.R. 965, 968-69 (S.D.N.Y. 1983).

[16] See, e.g., Acands, Inc. v. Travelers Cas. & Sur. Co., 435 F.3d 252, 260-61 (3d Cir. 2006).

[17] Fed. R. Bankr. P. 9019(a); 2002(a).