COMMITTEE ON MARINE INSURANCE AND GENERAL AVERAGE

NEWSLETTER, SPRING 2002

Editors: George N. Proios

Gene B. George

Joshua S. Force

I. NEWS AND INFORMATION

Protection Against Failure of a Bankrupt Member of a Mutual or

Reciprocal Insurance Association to Pay Supplemental Calls1

Consider a mutual or reciprocal hull insurance association whose members

pool their resources to insure each other against enumerated risks under

a series of yearly agreements. Each member pays an initial annual premium

based on considerations such as the size and value of its fleet. This initial premium

is augmented by “retrospectively rated” supplemental calls based on

the member’s individual loss record. The association also sets aside a contingency

fund available to a member sustaining a large, but not total, loss,

repayable by the member over a fixed period of years.

Concern may arise as to the prospects for payment by a member with an

accumulation of losses and deteriorating finances, facing growing supplemental

calls, or a member that has drawn from the contingency fund to pay

for repairs after a major casualty, but has poor liquidity and declining business

prospects. Companies in the asbestos, steel and other industries have

increasingly resorted to reorganization under Chapter 11 of the Bankruptcy

Code as a loss control device, and if that fails, liquidation under Chapter 7.

Can the association amend its rules to provide members greater assurance

that supplemental calls will be paid and that the contingency fund will be

repaid, or in the alternative that the impecunious member will be suspended

or expelled? This can be broken down into three subsidiary questions.

FIRST, can the association unilaterally terminate further participation

during the term of the insurance year by a member that has paid past premiums

and not otherwise breached the contract of insurance, solely because the

member becomes insolvent or files for bankruptcy court protection?—NO.

1 This article is not intended to be a comprehensive treatment of this complex subject, but represents

the results of some research done in a limited time in response to a recent inquiry.

[13060]

Any attempt to terminate further participation without first seeking

bankruptcy court approval appears to be prohibited by the “automatic stay”

provision of the Bankruptcy Code, which provides in part at 11 U.S.C. §362:

(a) Except as provided in subsection (b) of this section, a

petition filed under section 301, 302 or 303 of this title, or

an application filed under section 5(a)(3) of the Securities

Investor Protection Act of 1970 (15 U.S.C. 78eee(a)(3)),

operates as a stay, applicable to all entities of—

* * * *

(3) any act to obtain possession of property of the estate or

of property from the estate or to exercise control over property

of the estate.

Insurance contracts are included in the statutory definition of “property.” In

re Forty-Eight Insulation, Inc., 54 Bankr. 905 (Bankr. N.D.Ill. 1985); In re

Gamma Fishing Company, Inc., 70 Bankr. 949 (Bankr. S.D.Cal. 1987).

Since the 1978 amendments to the Code, neither insolvency nor the filing

of a bankruptcy petition alone justifies canceling an “executory contract.”

11 U.S.C. §365 (e) provides in part:

(e)(1) Notwithstanding a provision in an executory contract

or unexpired lease, or in applicable law, an executory contract

or unexpired lease of the debtor may not be terminated

or modified, and any right or obligation under such contract

or lease may not be terminated or modified, at any time

after the commencement of the case solely because of a

provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition

of the debtor at any time before the closing

of the case;

(B) the commencement of a case under

this title; or

(C) the appointment of or taking possession

by a trustee in a case under this

title or a custodian before such commencement.

[13061]

The “Historical and Statutory Notes” accompanying this section of the

U. S. Code state that the term “executory contract” has no precise definition,

but “generally includes contracts on which performance remains due to some

extent on both sides.” That definition would seem to apply to the remaining

period of coverage, since the member could present claims for new occurrences

or discover additional damage from previous casualties requiring

adjustment by the association, which in turn could require a supplemental

payment of premium by the member.

Generally, for 11 U.S.C. §365 to be applicable, the Bankruptcy

Code requires the existence of an executory contract on the day the debtor

files its petition for relief. Nemko, Inc. v. Motorola, Inc., 163 Bankr. 927, 935

(Bankr. E.D.N.Y. 1994). An executory contract may not be unilaterally

modified or terminated as to a debtor solely because of its financial condition

or the commencement of a case under the Bankruptcy Code. 11 U.S.C.

§365(e)(1).

Since filing a bankruptcy petition triggers the automatic stay provision

of the Bankruptcy Code, the next move is up to the Bankruptcy Trustee under

another provision of the Act. 11 U.S.C. §365 provides in part:

(a) Except as provided in sections 765 and 766 of this title

and in subsections (b), (c), and (d) of this section, the

trustee, subject to the court’s approval, may assume or reject

any executory contract or unexpired lease of the debtor.

SECOND, can the association seek payment in the bankruptcy proceeding

and have its claim given some priority over those of other creditors?—

PERHAPS.

If additional premiums are required from the member, there is some

authority to the effect that they can be classified as an administrative priority

expense under 11 U.S.C. §503, which provides in part:

(a) An entity may timely file a request for payment of an

administrative expense, or may tardily file such request if

permitted by the court for cause.

(b) After notice and a hearing, there shall be allowed,

administrative expenses, other than claims allowed under

section 502(f) of this title, including—

[13062]

(1)(A) the actual, necessary costs and

expenses of preserving the estate,

including wages, salaries, or commissions

for service rendered after the commencement

of the case;

In In re Gamma Fishing Company, Inc., 70 Bankr. 949 (Bankr. S. D.Cal.

1987), a debtor fishing company filed a Chapter 11 bankruptcy petition, after

which a creditor insurance company sought to have an overdue premium on

a marine liability policy paid in full as an “administrative expense” under

§503. The one-year policy called for quarterly premiums, two of which had

been paid, and the third and fourth of which were due when the petition was

filed.

The court found the contract was “executory,” but that the trustee had not

obtained specific court approval for its assumption under §365. However, the

policy premiums were a necessary cost because “[t]he purchase of insurance

is a recognized means of protecting and preserving the estate.” 70 Bankr. at

953. Therefore the creditor was entitled to have the premiums due post-petition

treated as a priority “administrative expense” by the trustee.

Because the automatic stay provision of §362(a)(2) prohibited the creditor

insurer from terminating the contract even though the debtor was in

default, the court reasoned that the debtor fishing company had the benefit of

the coverage, for which it should pay the post-petition premiums. Finding no

directly controlling authority, the court resorted to the analogy of a rental

agreement with a debtor that continues to use the property without assuming

or rejecting the executory contract:

Such authority provides that the amount of compensation

to the non-debtor lessor is presumably determinable by an

allocation of the rent reserved in the lease on a pro rata

basis for the term of the debtor’s possession since the date

of the petition.…

Accordingly, this court holds that a debtor receiving necessary

benefits from a pre-petition executory insurance

contract must accord the non-debtor party an administrative

expense priority for the pro rata share of the premium,

during the period in which the estate received benefits

from the contract.

[13063]

70 Bankr. at 955. While the case involved a policy with fixed quarterly premiums,

its reasoning and the statutory language should extend to supplemental

calls based on loss experience, since in either case the purchase of

insurance serves to preserve the estate.

THIRD, can the association provide for security against failure to pay

supplemental calls or repay the contingency fund, free from bankruptcy court

involvement?—YES.

Two possible methods of securing payment would be a mortgage or letter

of credit. To avoid violating the intention of 11 U.S.C. §365, which bars

modification of executory contracts on the basis of insolvency or the commencement

of a case under the Bankruptcy Code, either of these means of

securing payment would have to apply equally to all members.

The rules of the association could be revised to require that all members’

repayment obligations are secured by maritime liens and/or first preferred

ship mortgages. Presumably, this option would be undesirable to shipowners

and their existing mortgagees, and might provide little or no security if the

primary asset of the impecunious member is a mortgaged vessel that has just

sustained major damage.

The alternative security device, a letter of credit, has been employed in

analogous contexts involving other sorts of “retrospectively rated” property

insurance policies, such as those covering fleets of corporate automobiles.

Any attempt to enforce payment by foreclosing on a mortgage would

entail requesting the bankruptcy court to lift the “automatic stay” of all

actions against the debtor or its property, since the ship or other property

securing the mortgage has become property of the debtor’s bankruptcy

estate. A stand-by letter of credit avoids this difficulty:

Although a debtor’s obligations can be secured in an infinite

number of ways, the most common and reliable form

of security for a retrospective premium insurer is the standby

letter of credit. Indeed, in bankruptcy, a letter of credit

is often far superior to a traditional security interest in the

debtor’s property, which presumably has become property

of the debtor’s bankruptcy estate and hence involves the

burden of first having to seek relief from the automatic stay

in order to foreclose on the collateral. In contrast, a letter

of credit is viewed as the independent obligation of the

[13064]

bank that issued it. It is not deemed property of the

debtor’s estate but rather the property of the creditor.

Accordingly, the beneficiary of a letter of credit should not

be required to move to lift the automatic stay before drawing

down the credit, regardless of whether the debtor’s

obligation to the bank is itself secured by property of the

estate. Furthermore, a letter of credit is generally insulated

from attack under the debtor’s statutory powers to avoid

unperfected liens and to recover preferential and fraudulent

transfers. Thus, the retrospective premium insurer that

has sufficiently secured the debtor’s premium obligations

with a letter of credit upon the issuance of the policy lives

in the best of all possible worlds, should the insured later

file for bankruptcy. Of course, in the event that the letter of

credit is insufficient to cover all of the debtor’s premium

obligations, the insurer will still be able to assert a general

unsecured deficiency claim for the balance and potentially

even a priority administrative expense claim.

Ledwin, “The Treatment of Retrospectively Rated Insurance Policies in

Bankruptcy,” 16 Bankruptcy Developments Journal 11, 16–17 (1999).

An amendment to the rules of the association requiring that all members

secure such letters of credit, taking effect before any member seeks bankruptcy

court protection, should not violate the Bankruptcy Code. It offers

substantial security for future payments free of bankruptcy court regulation.

Submitted by Gene B. George

II. RECENT CASES OF INTEREST

Insured Fails to Satisfy Fraudulent Bills of Lading Clause in Cargo

Policy

Centennial Ins. Co. v. Lithotech Sales, LLC, 2002 U. S. App. LEXIS 3287,

2001 AMC 1046 (3rd Cir. 2002)

The Third Circuit affirmed the district court’s grant of summary judgment

in favor of a plaintiff insurance company against a defendant who was

the assignor and predecessor in interest of appellant. The trial court held that

the defendant had failed to articulate facts sufficient to invoke coverage

[13065]

under the Fraudulent Bills of Lading Clause in its marine open cargo policy.

Consequently, the defendant could not establish that the policy covered its

alleged economic loss resulting from the shipment of a Heidelberg printing

press different from that described in bill of lading.

The circuit court agreed with the district court that New Jersey law

applied to the policy, which was drafted, signed and delivered between New

Jersey corporations in New Jersey. In New Jersey, absent ambiguity, the

terms of an insurance policy are given “their plain ordinary meaning.” The

clause in question was deemed unambiguous:

This policy also covers loss of or damage to the property

insured occasioned through the acceptance by the Insured

or Insured’s agent or customer or consignees or others of

Fraudulent Bills of Lading or Shipping Receipts.

Moreover, even if there was loss of or damage to the printing press, the

record did not contain facts establishing that the bill of lading was fraudulent

or that its acceptance caused the harm.

While suggesting a fraudulent scheme to substitute a different press, the

insured did not show that the bill of lading “was drafted inaccurately with the

specific intent to deceive.” Merely listing inaccuracies in a bill of lading was

insufficient to establish coverage: “Simply because a fraud happened somewhere

at sometime does not necessarily mean that the bill of lading was

fraudulent, as it must be for coverage under the Fraudulent Bills of Lading

Clause.”

The insured also failed to show that the loss or damage was caused by

acceptance of the bill of lading as required. Even if the press (the serial number

of which matched that on the bill of lading) was severely worn, rusted

and fire-damaged, there was no indication that the damage had occurred

because of any inaccuracies or fraud in the bill of lading.

Third Party Liability Clause in Builder’s Risk Policy Does Not Cover

Costs of Litigation Between Principal Assureds

Norfolk Shipbuilding & Drydock Corp. v. Seabulk Transmarine Partnership,

Ltd., 274 F.3d 249, 2002 AMC 363 (5th Cir. 2001)

In a breach of contract suit by a vessel owner, the defendant shipbuilder

asserted its right to recover litigation defense costs from the parties’ joint

[13066]

insurer. Applying Florida law, the Fifth Circuit affirmed the district court’s

denial of recovery, holding that the general third party liability clause in a

builder’s risk policy did not provide the builder with coverage for the cost of

defending against the vessel owner’s claim.

Where the builder’s risk policy named both the shipbuilder and vessel

owner as principal assureds, the owner was not a “third party” for purpose of

builder’s coverage. The policy’s cross-liabilities clause, which guaranteed

that neither assured would receive less coverage than would be available

under separate policies, only applied when one assured sought to hold the

other liable for a claim by a third party.

The Florida rule that policies must be construed in favor of the insured

was inapplicable where the policy provision was clear and free from uncertainty,

inconsistency and ambiguity. Moreover, parol evidence was inadmissible

to explain unambiguous policy terms.

Insured’s Violation of Conspicuous Captain Warranty Clause Suspends

Coverage

Yu v. Albany Ins. Co., 281 F.3d 803, 2002 AMC 660 (9th Cir. 2002)

The Ninth Circuit, applying Hawaii law, affirmed the trial court’s grant

of summary judgment in favor of an insurer in an action by an insured vessel

owner to recover damages under a marine insurance policy following the

sinking of a fishing vessel. The insured’s violation of a Captain Warranty

clause was held to suspend coverage, whether or not the violation was shown

to have caused the loss.

The Captain Warranty Clause provided as follows:

It is understood and agreed that the Captain of the vessel is

Gregory P. Walker, and it is warranted by the Assured that

Gregory P. Walker shall be aboard at all times the vessel is

navigating. If Gregory P. Walker is not aboard the vessel

while it is navigating, and if Underwriters have not previously

agreed to a suitable replacement, coverage under this

policy shall be suspended until Gregory P. Walker returns

to the Vessel.

A replacement captain, not previously agreed to by underwriters, was

aboard at the time of the sinking. The plaintiffs’ contention that the broker

[13067]

was notified of the substitution via telephone message was deemed insufficient

to comply with the warranty, where the underwriters had not “agreed

to” the replacement captain before the sinking. Consequently, the Captain

Warranty Clause, which was deemed unambiguous and not rendered unenforceable

by the parties’ prior course of dealing, was violated, resulting in the

suspension of coverage.

According to the court, the clause was also sufficiently

conspicuous:

The Captain Warranty was printed in bold, underlined,

capitalized letters, making it conspicuous. The Captain

Warranty was also conspicuous because it had blanks filled

with the name “Gregory P. Walker,” which was typed in a

different font and size from the lettering on the rest of the

page, drawing one’s attention to it. Moreover, the Captain

Warranty was one of only six special conditions placed on

that page. Finally, when the policy was forwarded to the

Yus’ attention by [the broker,] Kudlich, Kudlich’s letter

specifically called the Yus’ attention to the Captain

Warranty, warning the Yus that “[f]ailure to abide by this

warranty could null and void the insurance policy.”

Admiralty Jurisdiction and Uberrimae Fidei Apply to Marine Insurance

Dispute Involving Wooden Drydock

Commercial Union Ins. Co. v. Detyens Shipyard, Inc., 147 F. Supp.2d 413,

2001 AMC 2121 (D.S.C. 2001)

In a declaratory judgment action by a marine insurer to determine coverage

under P & I and hull policies as to a wooden drydock allegedly

destroyed during a hurricane, the insured’s motion for summary judgment

was granted in part and denied in part.

First, the district court held that the litigation fell within federal admiralty

jurisdiction because the subject matter of the insurance contracts was

maritime in nature. A floating wooden drydock moored to shore and used

exclusively as a drydock was not a “vessel,” but was a “marine interest”

because it played “an integral role in the operation and maintenance of ships

and other vessels—a crucial maritime activity.” Likewise, risks insured

against in a hull coverage clause were predominantly “marine risks”, according

to the court.

[13068]

In the court’s view, no justiciable issue arose regarding the applicability

of the P & I policy’s wreck removal provision, which was triggered by a

removal order issued under statutory authority or in some other manner prescribed

by law, because the government had not mandated removal of the

drydock.

In addition, the court stated that the insurer and the drydock owner were

both bound by the “firmly entrenched federal doctrine” of uberrimae fidei,

which was applicable in cases involving marine insurance contracts, where

no South Carolina law or Fourth Circuit case law mandated a contrary conclusion.

The court thus denied the insured’s motion for partial summary

judgment on the insurer’s claim that the policies were void ab initio due to

insured’s misrepresentations and/or nondisclosures, because issues of material

fact existed as to the drydock owner’s compliance with the disclosure

requirements of uberrimae fidei in its application for coverage.

____________________________________________________

Newsletter Editors’ Note: Items for future issues may be submitted to George

N. Proios, Lyons, Skoufalos, Proios & Flood, 1350 Broadway, New York,

NY 10018; Gene B. George, Ray, Robinson, Carle & Davies P.L.L., 1650

The East Ohio Building, 1717 East 9th Street, Cleveland, OH 44114; Joshua

S. Force, Sher Garner Cahill Richter Klein McAlister & Hilbert, L.L.C.,

Twenty-Eight Floor, 909 Poydras Street, New Orleans, Louisiana 70112-

1033