The Fidelity Law Journal... 236 Fidelity Law Journal, Vol. XVIII, November 2012 rights impaired by its insured. Part IV deals with procedural issues that may affect an insurer’s

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The Fidelity

Law Journal

published by The Fidelity Law Association

Volume XVIII, November 2012

Cite as XVIII Fid. L.J. ___ (2012)

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The Fidelity Law Journal is published annually. Additional copies may be purchased by writing to: The Fidelity Law Association, c/o Wolff & Samson PC, One Boland Drive, West Orange, New Jersey 07052.

The opinions and views expressed in the articles in this Journal are solely of the authors and do not necessarily reflect the views of the Fidelity Law Association or its members, nor of the authors’ firms or companies. Publication should not be deemed an endorsement by the Fidelity Law Association or its members, or the authors’ firms or companies, of any views or positions contained herein. The articles herein are for general informational purposes only. None of the information in the articles constitutes legal advice, nor is it intended to create any attorney-client relationship between the reader and any of the authors. The reader should not act or rely upon the information in this Journal concerning the meaning, interpretation, or effect of any particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney.

The information in this Journal does not amend, or otherwise affect, the terms, conditions or coverages of any insurance policy or bond issued by any of the authors’ companies or any other insurance company. The information in this Journal is not a representation that coverage does or does not exist for any particular claim or loss under any such policy or bond. Coverage depends upon the facts and circumstances involved in the claim or loss, all applicable policy or bond provisions, and any applicable law.

Copyright © 2012 Fidelity Law Association. All rights reserved. Printed in the USA. For additional information concerning the Fidelity Law Association or the Journal, please visit our website at http://www.fidelitylaw.org.

Information which is copyrighted by and proprietary to Insurance Services Office, Inc. (“ISO Material”) may be included in this publication. Use of the ISO Material is limited to ISO Participating Insurers and their Authorized Representatives. Use by ISO Participating Insurers is limited to use in those jurisdictions for which the insurer has an appropriate participation with ISO. Use of the ISO Material by Authorized Representatives is limited to use solely on behalf of one or more ISO Participating Insurers.

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Harvey C. Koch and Ashley L. Belleau are Partners with Montgomery Barnett, LLP in New Orleans, Louisiana. Patrick J. Collins is Managing Attorney with Collins & Coldwell, LLC in Denver, Colorado. 235

EFFECTING RECOVERY AND SUBROGATION IN SPECIALIZED SITUATIONS

Harvey C. Koch Ashley L. Belleau Patrick J. Collins

I. INTRODUCTION

For an insurer, issues of recovery after paying a claim are an important aspect of the claims process. The subrogation action can be a valuable tool against third parties who are ultimately responsible for the insured’s loss. For fidelity insurers, potential targets usually include company directors, officers, or employees who have defrauded or stolen from their company in some way. The Mandatory Victims’ Restitution Act can be invaluable for an insurer to recover claim outlays in such situations, especially against the third party’s retirement accounts, through subrogation. Subrogation principles often involve unique issues and vary dramatically from state to state. Local counsel who are familiar with the subrogation laws of their own jurisdiction are critical to the successful prosecution of subrogation claims.

This article focuses on effecting recovery based on an insurer or surety’s subrogation rights in specialized circumstances, including under the Mandatory Victims’ Restitution Act, during bankruptcy proceedings, and when subrogation rights have been impaired. Part II deals with the effects of the Mandatory Victims’ Restitution Act on a company’s, and by extension its subrogated fidelity insurer’s, ability to recover restitution from criminally liable employees, specifically from those employees’ retirement accounts. Part III discusses impairment of subrogation issues, including how an insurer can protect itself from having its subrogation

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236 Fidelity Law Journal, Vol. XVIII, November 2012

rights impaired by its insured. Part IV deals with procedural issues that may affect an insurer’s pursuit of its subrogation rights, such as the insurer’s standing to bring an action for partial subrogation, when actions may be brought, and the judicial imposition of constructive trusts to protect funds subject to subrogated rights. Part V focuses on how to mitigate the effects of bankruptcy on recovery.

II. THE ABILITY OF A “VICTIM” TO COLLECT PENSION FUNDS

FROM THE WRONGDOER PURSUANT TO THE MANDATORY VICTIMS RESTITUTION ACT OF 1996

A. Treatment of Cases Dealing with Traditional Recovery

Prior to the early 1980s restitution was only imposable as a condition of supervision under the Federal Probation Act of 1925.1 Until 1982, a restitution order could not be imposed as a separate component of a federal criminal sentence. Since that time, there has been a movement to make the judicial system more sympathetic to victims’ interests. From 1982 to 1996, Congress provided that, in addition to paying fines to the United States, criminals should be held liable to the private individuals and institutions victimized by their crimes.

The federal statutory restitution scheme began with the 1982 passage of the Victim and Witness Protection Act.2 Prior to that time, judges could only order restitution as a condition of probation and such orders were infrequently used. VWPA authorized and encouraged courts to impose restitution independent of probation. While the VWPA was a step forward, it enhanced the power of the United States, not private victims, to enforce collection of restitution.

The Supreme Court held that under the VWPA “restitution may be ordered only for losses caused by the specific conduct that is the basis of the offense or conviction.”3 If a defendant failed to pay restitution ordered by a federal court, either the United States or the victim named

1 Codified at 18 U.S.C. § 3651-56, repealed November 1, 1987. 2 Pub. L. No. 97-291, 96 Stat. 1248 (1982) [hereinafter VWPA]. 3 Hughey v. United States, 495 U.S. 411 (1990).

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Effecting Recovery and Subrogation in Specialized Situations 237

in the restitution order could enforce the order “in the same manner as a judgment in a civil action.”4 Judgments in civil actions could be satisfied by following the procedures available under the law of the state in which the court was located, except that “a federal statute governs to the extent that it applies.”5 Importantly, under the VWPA a court was required to determine whether a defendant had the financial stability to make restitution in light of “the financial resources of the defendant, the financial needs and earning ability of the defendant and the defendant’s dependents, and such other factors as the court deems appropriate.”6

In 1990 Congress enacted the Federal Debt Collection Procedure Act,7 which provides “civil procedures for the United States . . . to recover judgment on a debt,” and “shall not apply with respect to an amount owing that is not a debt.”8 However, the FDCPA was limited in its application to private victims as “debt” was defined as “an amount that is owing to the United States.”9

In 1996, Congress made the most significant change to the statutory restitution scheme by enacting the Mandatory Victim Restitution Act.10 In so doing, Congress mandated restitution of all victims while enhancing collection and enforcement rules. In a noticeable departure from the previous statutory restitution scheme, the MVRA discarded the discretionary analysis and instead mandated that a court “order restitution to each victim in the full amount of each victim’s losses as determined by the court and without consideration of the economic circumstances of the defendant.”11 Unlike the language of the

4 18 U.S.C. § 3663(h)(1)(b), repealed by Pub. L. No. 104-132,

§ 205(a)(2). 5 FED. R. CIV. P. 64(a); FED. R. CIV. P. 69(a)(1). 6 18 U.S.C. § 3663(a)(1)(B)(i)(II) (1994). 7 Hereinafter FDCPA. 8 28 U.S.C. § 3001(a)(1), (c). 9 28 U.S.C. § 3002(3)(B). 10 Pub. L. No. 104-132, 110 Stat. 1227 (1996) (codified at 18 U.S.C. §

3663A) [hereinafter MVRA]. 11 18 U.S.C. § 3664(f)(1)(A).

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VWPA, under the MVRA a defendant’s financial status only becomes relevant when fixing a payment schedule to a restitution order.12

The MVRA gives high priority to private-victim restitution orders. Specifically, Congress gave the payment of “restitution of all victims” higher priority than payment to the United States of fines and costs.13 Additionally, the MVRA provides that, in cases where the United States and a private victim are owed restitution, “the court shall ensure that all other victims receive full restitution before the United States receives any restitution.”14

Congress’s primary motivation in enacting the MVRA was the belief that the VWPA’s restitution framework did not adequately compensate victims of crimes. By mandating that judges order restitution in the full amount of victims’ losses, Congress aspired to ensure that victims “receive the restitution that they are due.”15

In its statutory notes for 18 U.S.C. § 3663A, Congress made the MVRA applicable to defendants “convicted on or after April 24, 1996,” which was the date of enactment.16 Thus, even defendants who committed crimes before the enactment of the MVRA can be sentenced according to the guidelines of the MVRA if they were convicted on or after April 24, 1996.

The MVRA is inapplicable to defendants convicted before the date of the MVRA amendments.17 If a defendant were convicted prior to April 24, 1996, the restitution order would be governed by the principles

12 United States v. Newman, 144 F.3d 531 (7th Cir. 1998); 18 U.S.C. §

3664(f)(1)(A). 13 Pub. L. No. 104-132, § 207(c)(2); 18 U.S.C. § 3612(c). 14 18 U.S.C. § 3664(i). 15 Matthew Dickman, Should Crime Pay?: A Critical Assessment of the

Mandatory Victims Restitution Act of 1996, 97 CALIF. L. REV. 1687 (2009). 16 18 U.S.C. § 2248, Pub. L. No. 104-132, § 211. 17 United States v. Rostoff, 164 F.3d 63, 66 n.3 (1st Cir. 1999); United

States v. Timilty, 148 F.3d 1, 2 n.1 (1st Cir. 1998); United States v. Bongiorno, 110 F.3d 132, 133-34 (1st Cir. 1997).

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of the VWPA, which grants district judges greater discretion when imposing restitution orders.18

1. United States v. Newman

In United States v. Newman,19 Defendant Willie Newman robbed a bank five days prior to the enactment of the MVRA. Although Newman’s crime was committed before the MVRA was enacted, he was sentenced after the act was in effect. Pursuant to the language of the MVRA, the district court ordered Newman to make mandatory restitution payments to the bank.20 Newman appealed his case to the U.S. Court of Appeals for the Seventh Circuit. In his appeal, Newman argued that the district court’s application of the MVRA violated the Ex Post Facto Clause of the Constitution. Specifically, Newman argued that the MVRA increased the punishment of a crime that was committed prior to its enactment and that the VWPA should apply as the controlling restitution statute.

The Seventh Circuit concluded that the MVRA did apply to Mr. Newman’s case and that its application did not violate the Ex Post Facto Clause. The court held that applying an act retroactively does not violate the Constitution unless it disadvantages a defendant by “altering the definition of criminal conduct or increasing the punishment for a crime.”21 The court reasoned that a restitution order does not increase the punishment of a crime. Instead, it is based in equity and seeks to make whole a victim of a crime. As such, a restitution order prevents a wrongdoer from profiting from his actions and is distinct from any criminal punishment a court may apply.

18 See 18 U.S.C. § 3663; 18 U.S.C. § 3663A. 19 144 F.3d 531 (7th Cir. 1998). 20 Id. at 537; 18 U.S.C. § 3663A(a)(1) & (b). 21 Id. at 538 (quoting Lynce v. Mathis, 519 U.S. 433, 441 (1997) &

Weaver v. Graham, 450 U.S. 24, 29 (1981)).

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B. Summary of 18 U.S.C. § 3663A, Mandatory Restitution to Victims of Certain Crimes

The MVRA is codified at 18 U.S.C. § 3663A. Under the terms of the statute, the MVRA mandatorily applies to three types of crimes: (1) crimes of violence; (2) offenses against property under Title 18, including those of fraud and deceit; and (3) certain offenses dealing with tampering of consumer products.22 In such a case, the MVRA shall be applicable when an identifiable victim or victims have suffered a physical injury or pecuniary loss.23

The MVRA requires every felony offender to pay restitution, in addition to any other penalty, to the victim or the victim’s estate. The Act requires that the defendant return property to the rightful owner, or, if impracticable, pay an amount greater than the value of the property on the date of loss or sentencing. Discretionary restitution is authorized in cases of misdemeanor offenders, as a court may order restitution in addition to or in lieu of any other penalty authorized by law.

While the MVRA applies only to cases in which “an identifiable victim or victims has suffered a physical injury or pecuniary loss[,]”24 “victim” is defined quite broadly under the language of the Act. In particular, a “victim” is defined as follows:

a person directly and proximately harmed as a result of the commission of an offense for which restitution may be ordered, including, in the case of an offense that involves as an element of a scheme, conspiracy, or pattern of criminal activity, any person directly harmed by the defendant’s criminal conduct in the course of the scheme, conspiracy, or pattern.25

22 United States v. Stephens, 374 F.3d 867 (9th Cir. 2004); see

§ 3663A(c)(1)(A). 23 18 U.S.C. § 3663A. 24 18 U.S.C. § 3663A(c)(1)(B). 25 18 U.S.C. § 3663A(a)(2).

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Further, the MVRA states that in any case, be it a misdemeanor or felony, the defendant must reimburse the victim for lost income and necessary childcare, transportation, and other expenses incurred during the participation and in the investigation or prosecution of the offense or attendance at proceedings related to the offense.26

C. Summary of 18 U.S.C. § 3664, Issuance and Enforcement of Restitution Orders

Procedures for the issuance and enforcement of restitution awards under the MVRA are discussed in 18 U.S.C. § 3664. Under section 3664, a court shall order the probation officer to include information in its presentence report pertinent to the court’s ability to command an appropriate restitution order. Specifically, the report must include a complete accounting of the losses to each victim, any restitution owed pursuant to a plea agreement, and information relating to the economic circumstances of each victim.

As to the amount of the award, section 3664 makes it clear that while the court requires specific financial information from the defendant, the order of restitution shall be for the full amount of the victim’s losses.27 The defendant’s financial status is relevant only to payment type and payment schedules but is not relevant when calculating the amount of restitution to be paid. Restitution orders may take the form of a single payment, a lump sum payment, partial payments at specified intervals, in-kind payments, or a combination of such payments.28 If a defendant cannot make payments of any amount in the present or foreseeable future, the court may order the defendant to make “nominal periodic payments” to the victim.29

The fact that a victim has or is entitled to receive insurance compensation will not be considered in determining the restitution

26 18 U.S.C. § 3663A(b)(4). 27 “In each order of restitution, the court shall order restitution to each

victim in the full amount of each victim’s losses as determined by the court and without consideration of the economic circumstances of the defendant.” 18 U.S.C. § 3664(f)(1)(A).

28 18 U.S.C. § 3664(f)(1)(3)(A). 29 18 U.S.C. § 3664(f)(3)(B).

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amount.30 The Act uses specific language allowing an insurer to compensate for the loss to a victim, provided the victims are paid before any insurer. Section (j)(1) states as follows:

If a victim has received compensation from insurance or any other source with respect to a loss, the court shall order that restitution be paid to the person who provided or is obligated to provide the compensation, but the restitution order shall provide that all restitution of victims required by the order be paid to the victims before any restitution is paid to such a provider of compensation.

Section 3664 also explains how restitution orders are to be enforced. While Congress included section 3664 to describe enforcement mechanisms, Congress also relies on a complex hodgepodge of other statutes to solidify the enforcement of restitution orders. Section 3664(m)(1)(A) provides as follows: “(i) An order of restitution may be enforced by the United States in the manner provided for in subchapter C of chapter 227 and subchapter B of chapter 229 of this title; or (ii) by all other available and reasonable means.”

Stated simply, Congress uses 18 U.S.C. § 3613, Civil Remedies of an Unpaid Fine, to enforce restitution orders issued under the MVRA. Section 3613 is the backbone of judicial enforcement of a private-victim restitution order, as it permits the United States to enforce a judgment imposing a fine in accordance with the practices and procedures for the enforcement of a civil judgment under federal law or state law. Section 3613(a) states as follows:

“Notwithstanding any other Federal law (including section 207 of the Social Security Act), a judgment imposing a fine may be enforced against all property or rights to property of the person fined” (except for some

30 “In no case shall the fact that a victim has received or is entitled to

receive compensation with respect to a loss from insurance or any other source be considered in determining the amount of restitution.” 18 U.S.C. § 3664(f)(1)(B).

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limited circumstances including property exempt for a levy for taxes and provisions of the Consumer Credit Protection Act).

Additionally, the MVRA gives high priority to private-victim orders in particular.31 When allocating payments received by defendants, the MVRA mandates that “higher priority” be given to payment of the “restitution of all victims” than to payment of the United States of fines and costs.32 Further, section 3664(i) mandates that, where both the United States and a private victim are owed restitution, “the court shall ensure that all other victims receive full restitution before the United States receives any restitution.”33

1. The Effect of Section 3664 on Subsequent Litigation

Of particular importance to the insurance fidelity field is the preclusive effect that section 3664 has on the defendant in subsequent, related litigation. Section 3364(l) is extremely useful to the insurer in instances when civil litigation arises out of a criminal case. Specifically, section 3364(l) states as follows:

A conviction of the defendant for an offense involving the act giving rise to an order of restitution shall estop the defendant from denying the essential allegations of that offense in any subsequent Federal civil proceeding or State civil proceeding, to the extent consistent with State law, brought by the victim.

Section 3364(l) allows the victim to use a criminal conviction of the defendant as a judgment on the liability in a civil case, but only if restitution is ordered in the criminal case.34 Several advantages are evident from this language, including the effect on time and costs of preparing a case on the party seeking civil recovery.

31 United States v. Witham, 648 F.3d 40, 45 (1st Cir. 2011). 32 Id. See also Pub. L. No. 104-132, § 207(c)(2); 18 U.S.C. § 3612(c). 33 18 U.S.C. § 3664(i). 34 United States v. Stanelle, 184 F. Supp. 2d 854, 859 (E.D. Wis. 2002).

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Section 3364 also provides the victim with different mechanisms to effectuate recovery. As noted previously, section 3664(m)(1)(A) broadly permits a victim to recover by either methods described explicitly in the statute or “by all other available and reasonable means.”35 In addition, section 3612(c) made the United States responsible for the collection of unpaid restitution.36 In order for the state to enforce a restitution order for a private victim, the MVRA requires “each victim to notify the Attorney General” of contact information for restitution purposes.37

Finally, the MVRA provides the United States with the ability to “enforce a judgment imposing a fine in accordance with the practices and procedures for the enforcement of a civil judgment under Federal law or State law,”38 which includes the use of the Federal Debt Collection Procedure Act39 to enforce private victim restitution orders.

D. Conflict Between MVRA and ERISA

The Employee Retirement Income Act of 197440 regulates retirement accounts. ERISA was enacted to ensure that “retirement funds shall remain inviolate until retirement.”41 Under section 206 of ERISA, “each pension plan shall provide that benefits provided under the plan may not be assigned or alienated.”

However, MVRA rests on the recognition that “it is essential that the criminal justice system recognize the impact that crime has on the victim, and, to the extent possible, ensure that the offender be held accountable to repay these costs.”42 After passage of the MVRA, the

35 18 U.S.C. § 3664(m)(1)(A)(ii). 36 Pub. L. No. 104-132, § 207(c)(2); 18 U.S.C. § 3612(c) (“The

Attorney General shall be responsible for collection of an unpaid fine or restitution . . . .”).

37 Pub. L. No. 104-132, § 207(c)(2); 18 U.S.C. § 3612(b)(1)(G). 38 18 U.S.C. § 3613(a). 39 Hereinafter FDCPA. 40 29 U.S.C. §§1001-1461 [hereinafter ERISA]. 41 Boggs v. Boggs, 520 U.S. 833, 851 (1997) (quoting J. LANGBEIN &

B. WOLK, PENSION AND EMPLOYEE BENEFIT LAW 547 (2d ed. 1995)). 42 S. Rep. No. 104-179, at 18 (1995).

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ability of the statute to extend to recover from defendants’ retirement accounts came under question, due to the conflict apparent between the MVRA and ERISA.

E. Recent Case History Allowing Recovery from Pensions and 401(k)s

1. United States v. James

In United States v. James,43 Defendant Charles James was convicted of theft from a program receiving federal funds, in violation of 18 U.S.C. § 666. James was sentenced to twelve months imprisonment and ordered to pay $93,000 in restitution. In the event that restitution was not paid immediately, James was ordered to pay a monthly restitution of $150 until restitution was paid in full.

At the request of the government, the Clerk issued a Writ of Continuing Garnishment, which directed the garnishee to “withhold and retain any property in which the defendant has a substantial nonexempt interest and which the garnishee is or may become indebted to the defendant pending further order of the court.”44 James filed an answer to the Writ, in which he admitted that he possessed three separate IRA accounts, with a total value of $146,561. However, James claimed that the accounts were “exempt from the legal process as part of the retirement plans of private employers.”45 In claiming this exemption James relied on a Guidry v. Sheet Metal Workers National Pension Fund,46 which was decided before the enactment of the MVRA.

In Guidry, the Supreme Court recognized that, absent some exception to ERISA’s anti-alienation provision as contained in 29 U.S.C. § 1056(d)(1), that provision bars garnishment of pension benefits in an

43 312 F. Supp. 2d 802 (E.D. Va. 2004). 44 James, 312 F. Supp. at 804. 45 Id. 46 493 U.S. 365 (1990).

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ERISA plan. Specifically, the Supreme Court stated: “If exceptions to this policy are to be made, it is for Congress to undertake that task.”47

In enacting the MVRA, Congress accepted the Supreme Court’s invitation. Under section 3613(c), Congress mandated that for the purposes of enforcement, a restitution order is to be treated as “a lien in favor of the United States on all property and rights to property of the person fined as if the liability of the person fined were a liability for a tax assessed under the Internal Revenue Code of 1986.”48 In rendering a judgment in favor of the government, the United States District Court for the Eastern District of Virginia stated that, because section 3613 makes clear that restitution orders are to be treated as tax liabilities, like delinquent taxpayers, criminals defendants owing restitution to the government cannot keep their pension benefits from satisfying a restitution order. Further, the court noted that, “while there does not appear to be any controlling circuit authority, other district courts across the country have reached the same result.”49

As a practical matter, it is important to note the court decided that the fact that the defendant’s accounts were not specifically mentioned in the restitution order does not mean that the retirement accounts could not be used to satisfy the defendant’s restitution obligation. However, it is preferred that retirement plans are taken into account in the restitution order.

2. United States v. Novak

In United States v. Novak,50 the United States Court of Appeals for the Ninth Circuit faced the question of whether the United States government can garnish assets from a defendant’s retirement plan covered by ERISA to enforce a restitution order. The court was asked to determine if, and under what circumstances, a criminal defendant’s retirement benefits are available as a source of funds to compensate crime victims. In its judgment, the Ninth Circuit reconciled the federal

47 Id at 376. 48 18 U.S.C. § 3613(c). 49 James, 312 F. Supp. at 806. 50 476 F.3d 1041 (9th Cir. 2007).

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statutory schemes of the MVRA and ERISA. In a split decision, the court ruled that the government had a right to garnish funds from an ERISA plan, but only to the extent that the defendant has a right to receive payments under the terms of the plan.51

In Novak, Defendant Raymond Novak and his former wife engaged in a scheme to steal and resell telephone equipment from Nestle for over $3.3 million. Novak failed to report the earnings from this scheme on his federal tax return. In December 2002, Novak pled guilty to Conspiracy to Transport Stolen Goods,52 and Filing a False Tax Return,53 pursuant to a plea agreement. In its judgment, the district court ordered the defendant pay restitution in the total amount of $3,360,051 pursuant to the MVRA.54

The May Department Store employed Novak for 13 years, from which he was enrolled in the company’s retirement plans. Novak had earned benefits under the May’s Retirement Plan and the May’s Profit Sharing Plan. In accordance with the terms of both plans, after his dismissal, Novak had the ability to receive distributions of his benefits and accounts. Both plans were within the scope of ERISA.

By September 2003, Novak’s restitution payments were more than $3.3 million in arrears. Due to the enforcement mechanisms of 18 U.S.C. §§ 3664(m)(1)(A)(ii) and 3612(c)(2), the government is responsible for enforcing restitution orders and transferring collected funds to the victims. Due to the arrearage, the government moved for enforcement against Novak’s assets by applying for a writ of garnishment directed to the May Department Store, pursuant to the Federal Debt Collection Procedures Act.55

Novak moved to quash the Writ under the anti-alienation provision found in section 206(d)(1) of ERISA,56 arguing that it

51 Id. at 1063-64. 52 18 U.S.C. § 371. 53 26 U.S.C. § 7206(1). 54 Novak, 476 F.3d at 1043. 55 28 U.S.C. §§ 3101-3206. 56 29 U.S.C. § 1056(d)(1).

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prevented garnishment of retirement funds. The district court agreed with Novak, citing United States v. Jackson57 in its interpretation that the ERISA anti-alienation provision prevents garnishment of criminal restitution orders. After a divided panel reversed the lower court’s decision, the Ninth Circuit granted an en banc rehearing of the appeal.

The Ninth Circuit compared the “notwithstanding” language of section 361358 to the language of ERISA’s anti-alienation provision and found that the MVRA overrides ERISA in this case. In its analysis the Ninth Circuit focused its attention on four points. First, it concluded that Congress gave effect to the “notwithstanding” clause of the MVRA by placing it in conjunction with the “all property or rights to property” language of the Act. Second, it found that the MVRA expressly included Social Security retirement benefits into the reach of the “all property or rights to property” language. Third, the MVRA specifically excludes certain federal pensions that have their own anti-alienation provisions. Lastly, the Ninth Circuit concluded that, because the MVRA closely replicated language used in the federal tax levy statute, which has previously been construed by the courts to allow seizure of ERISA-protected retirement plan benefits, the MVRA can also be treated as overriding ERISA’s anti-alienation provision.

In its decision, the Novak court first examined the statutory language of the MVRA, which permits the enforcement of criminal restitution orders against “all property or rights to property,” "notwithstanding any other Federal law.”59 In United States v. National Bank of Commerce60 the Supreme Court emphasized the breadth of the “all property or rights to property” language, in determining that a tax collection statute using such language was meant to reach every interest in property. Because Congress chose to include the “all property” language used in tax collection statutes, the Novak court determined that

57 229 F.3d 1223 (9th Cir. 2000). 58 18 U.S.C. § 3613(a) states: “Notwithstanding any other Federal law

(including section 207 of the Social Security Act), a judgment imposing a fine may be enforced against all property or rights to property of the person fined . . . .”

59 18 U.S.C. § 3613(a) (emphasis added). 60 472 U.S. 713 (1985).

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“Congress had made quite clear that the totality of defendants’ assets will be subject to restitution orders.”61

The language of the Supreme Court requires that retirement plan benefits can be garnished to fulfill criminal restitution orders.62 However, ERISA ensures that benefits provided under a retirement plan may not be “assigned or alienated.”63 To remedy this problem, the Novak court reasoned that use of the “all property or rights to property” in conjunction with the “notwithstanding” clause “clearly signals Congressional intention that the provisions of the ‘notwithstanding’ section override conflicting provisions of any other section.”64

Next, the court determined that, by including section 207 of the Social Security Act into section 3613 of the MVRA and excluding four specific types of federally authorized pensions, Congress intended to allow the enforcement of restitution orders against retirement plan assets not otherwise mentioned. It deemed the failure to include ERISA into section 3613 to be of “substantial significance.”65

The Novak court determined that Congress included the section 207 language because the Social Security Act specifies that “no other provision of law . . . may be construed to limit, supersede, or otherwise modify the provisions of this section except to the extent that it does so by reference to this section.”66 The court reasoned that it was Congress’ intent to have the MVRA override the express provision in the Social Security Act. The court concluded that, because the ERISA anti-alienation provision did not include this clause, Congress did not need to mention ERISA explicitly when drafting the MVRA in order to override the anti-alienation provision.

61 Novak, 476 F.3d at 1046. 62 Id. 63 29 U.S.C. § 1056(d)(1); 26 U.S.C. §401(a)(13)(A). 64 Cisneros v. Alpine Ridge Group, 508 U.S. 10 (1993) (“The Supreme

Court has indicated as a general proposition that statutory ‘notwithstanding’ clauses broadly sweep aside potentially conflicting laws.”).

65 Novak, 476 F.3d at 1049. 66 42 U.S.C. § 407(b).

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The fact that Congress excluded certain retirement plans from mandatory restitution is of significance. In section 3613, Congress excluded four types of federally authorized pensions that each had their own anti-alienation provisions similar to ERISA.67 The Novak court reasoned that the fact that Congress “carved out” the specific retirement plans from application of the MVRA reinforces the notion that the anti-alienation provisions contained in federal pension statutes would not suffice to protect retirement benefits from private-victim garnishment and restitution orders. Accordingly, the court held that Congress intended the MVRA to include assets otherwise protected by ERISA.68

In its analysis, the court placed particular emphasis on the similar language used in both tax levy statutes and the MVRA. The court stated that section 3613 contains language “nearly replicating” the language used in “parallel” IRS statutes specifying the property subject to tax levies.69 Tax levy statutes have been construed as rendering ERISA inapplicable.70 By adopting nearly identical language to tax levy statutes, the court concluded that Congress specifically intended the language of the MVRA to render ERISA inapplicable, as in tax levy statutes.

In the next part of its analysis, the court set out to determine when a defendant’s retirement plan could be immediately garnished to enforce a restitution order. Under the language of the MVRA, a defendant’s interest in a retirement plan can only be garnished when the interest falls within the category of a “property or a right to property.”71 Because retirement plans differ widely in their terms, understanding when the property right in the plan “vests” is critical in determining when payments from an account can be compelled.

67 Railroad Retirement Act pensions, Railroad Unemployment Insurance Act benefits, pensions received by those on the Armed Forces Medal of Honor rolls, and certain provisions paid to military service members in lieu of retirement pay. 18 U.S.C. § 3613(a)(1) (citing 26 U.S.C. § 6334(a)(6)).

68 Novak, 476 F.3d at 1047. 69 Id. at 1049. 70 United States v. Taylor, 338 F.3d 947, 950 (8th Cir. 2003); McIntyre

v. United States (In re McIntyre), 222 F.3d 655, 660 (9th Cir. 2000); Shanbaum v. United States, 32 F.3d 180, 183 (5th Cir. 1994) (per curiam).

71 18 U.S.C. § 3613(a).

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The Novak court again draws on the similarity between the MVRA and tax levy statutes and determined that, under the “steps into the taxpayer’s shoes” principle,72 the government can “immediately garnish the corpus of a retirement plan to satisfy a MVRA judgment . . . if, but only if, the terms of the plan allow the defendant to demand a lump sum payment at the present time.”73

Therefore, if the defendant has the ability to compel lump sum payments from a retirement account, the party seeking garnishment of the account to enforce a private-victim restitution order can step into the defendant’s shoes and demand the same type of payment to enforce the order. However, the ability to garnish the retirement account only reaches as far as the defendant’s original rights as defined in the policy. It should also be noted that the ability to unilaterally garnish a retirement plan is unavailable when its required that lump sum payments be made payable only with spousal consent.74 This limitation accords with the policy to protect “blameless” dependants.75

3. United States v. Witham

In United States v. Witham,76 the United States Court of Appeals for the First Circuit determined that the FDCPA may be used to enforce an order of restitution to a private-party victim of a crime.

The question before the Witham court was whether the precedent set in United States v. Bongiorno77 was still controlling the issue of the application of the FDCPA. In Bongiorno, the First Circuit held that the government could not use the FDCPA to enforce private-victim restitution orders because the restitution was not a “debt” under the definition of the term “owing to the United States.” The district court in

72 United States v. Nat’l Bank of Commerce, 472 U.S. 713, 725 (1985) (quoting United States v. Rodgers, 461 U.S. 677 (1983)).

73 Novak, 475 F.3d at 1063. 74 See I.R.S. Priv. Ltr. Rul. 200426027, at *12, 2004 PLR LEXIS 315,

at *23-24. 75 Guidry v. Sheet Metal Workers Nat’l Pension Fund, 493 U.S. 365,

376 (1990). 76 648 F.3d 40 (1st Cir. 2011). 77 106 F.3d 1027 (1st Cir. 1997).

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Witham held that the precedent set in Bongiorno precluded the government from invoking the FDCPA to collect restitution owed to a private victim under the MVRA by determining that the FDCPA does not apply on its own terms to restitution owed to private victims.78

In reversing the district court, the First Circuit reasoned “nothing in the MVRA limits its authorization of the United States to use the FDCPA procedures only to restitution orders in favor of the United States, as opposed to private-party victims.”79 The court noted that the enforcement section 3613 does not distinguish between government or private party recovery. Furthermore, the only section of the MVRA that distinguishes between sovereign and private-victim recovery prioritizes “full restitution” of all private victims before the United States,80 supporting the view that the FDCPA may be used to enforce private restitution orders.

F. Practical Tips

1. United States v. Hosking

United States v. Hosking81 is an interesting case with several practical implications. In Hosking, the Seventh Circuit affirmed the principle of including a private victim’s investigative costs in the restitution award. However, when awarding proper restitution, the court required specific findings regarding the amount of such costs.

In Hosking, Defendant Jean Hosking worked for the Cross Plains Bank in Cross Plains, Wisconsin. Starting in 1994, Hosking embezzled more that $500,000 from the bank’s Environmental Cleanup Fund loan program. At sentencing, the bank requested restitution of $1,144,890, while the probation office recommended a reduced award of $712,777, which included over $500,000 in embezzled funds, over $200,000 for the bank’s in-house staff costs, and $4,250 for paper and copying expenses.82

78 United States v. Witham, 757 F. Supp. 2d 91, 94 (D.N.H. 2010). 79 United States v. Witham, 648 F.3d 40, 48 (1st Cir. 2011). 80 18 U.S.C. § 3664(i). 81 567 F.3d 329 (7th Cir. 2009). 82 Hosking, 567 F.3d at 331.

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Hosking objected, arguing that there was insufficient documentation to support an award for in-house costs. In response, the government submitted minutes from the bank’s meetings relating to the investigation; a declaration of losses from the bank; a description of the environmental loan process and Hosking’s embezzlement scheme; and a description of each expense the bank incurred in the investigation. The government also submitted invoices and a listing of in-house staff members and the hours they spent on the project.

The district court awarded $627,896 in restitution, including over $500,000 for embezzlement from the bank and $125,649 for the bank’s “investigation costs.” Included in “investigation costs” were: $6,734 for legal fees, $11,655 for accounting consultant fees; $4,250 for paper and copying services; and over $103,000 for in-house staff costs. In its Order, the district court failed to explain why the amount awarded for in-house staff costs was half of what was recommended by the probation office. The district court also ordered Hosking to make an immediate lump-sum payment of $100,000 from her retirement account.

In her appeal, Hosking argued that the district court abused its discretion by including the bank’s investigation costs in the restitution award, because the only “actual loss” she caused was the amount she embezzled, labeling the additional amount the bank spent as “consequential damages.” The Seventh Circuit denied the appeal, holding that the MVRA required the convicted defendant to make restitution to the victims of the offense to an “amount equal to the value of the property damaged or lost.”83 The MVRA also expressly includes the cost of “lost income and necessary child care, transportation, and other expenses incurred during participation in the investigation or prosecution of the offense or attendance at proceedings related to the offense.”84

In Hosking, the Seventh Circuit found that the time and effort spent by the bank’s employees and outside professionals in understanding the twelve-year embezzlement scheme “was a direct and foreseeable result of the defendant’s conduct that contributed to the

83 18 U.S.C. §§ 3663A(a)(1) & (b). 84 18 U.S.C. § 3663A(b)(4) (emphasis added).

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diminution of the value of the bank’s property.”85 In sentencing, the court determined that it was important that the sentencing judge only included those costs related to uncovering Hosking’s fraud and that, in so doing, the restitution order was not an abuse of discretion.

During the sentencing in Hosking the district court was presented only a single document supporting the inclusion of the bank’s in-house restitution award. The document simply listed the name and title of each employee who worked on the project and their hourly wage. What followed was a brief, two-paragraph explanation of the scope of the investigation, with no attempt to detail what part of the investigation each employee actually undertook. The Seventh Circuit found that the brief description of the employee’s roles failed to demonstrate what costs were proximately caused by Hosking’s conduct. As such, the case was remanded so that the government could provide a more detailed description of each employee’s role in the investigation to the district court.86

Hosking also objected to the district court’s order demanding her to make a lump-sum payment of $100,000 from her retirement account, which would leave only a $15,000 balance remaining. Hosking argued that the district court erred by failing to take into account her financial position.

In approving the district court’s restitution order, the Seventh Circuit noted that the MVRA allows a restitution order to take the form of several types of payments, including a lump-sum payment.87 Further, the restitution order may be enforced “by all available and reasonable means.”88 The Seventh Circuit noted that section 3572 “creates a preference” for immediate payment.89 The court reasoned that, while Hosking’s IRA “represented her only source of savings for retirement other than Social Security payments,” the district court did not abuse its

85 Hosking, 567 F.3d at 332. 86 Id.at 336. 87 18 U.S.C. § 3664(f)(3)(A). 88 Id. § 3664(m)(1)(A)(ii). 89 Hosking, 567 F.3d at 336 (citing United States v. Coates, 178 F.3d

681, 684 (3d Cir. 1999)).

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discretion by ordering the immediate payment of $100,000, followed by nominal payments thereafter.

2. United States v. Amato

In United States v. Amato,90 a business executive, his lawyer, and an officer of the company conspired together to commit a series of frauds against several states and a corporation that had purchased the small company that employed the individuals. The lawyer, John Fasciana, and the officer, Joseph Amato, were found guilty of fraud; and the district court ordered them to make restitution.

The district court found that a restitution award to the victims of $12,800,000, of which over $3,000,000 was for attorney’s fees, was reasonable, within the statutory language of the MVRA. Specifically, the court found that attorney’s fees fall within the “other expenses” as stated in section 3664(b)(4) because the costs were “so obviously associated with the investigation and prosecution, particularly in the case of fraud offenses.”91

The defendants appealed and argued that a restitution order could not encompass attorney’s fees and accounting costs because such costs only amount to indirect or consequential damages. The Second Circuit denied the appeal, reasoning that in this case the defendants perpetrated a complicated fraud against a large corporation, a number of clients, and the states to which those clients were required to turn over escheated funds. Because of the complexity and length of the fraud scheme, the Second Circuit determined “this fraud would force the corporation to expend large sums of money on its own internal investigation as well as its participation in the government’s investigation and prosecution of defense.” As such, “there is no doubt” that the victim’s attorney’s fees and auditing costs were a direct and foreseeable result of the defendants’ offenses.

90 540 F.3d 153 (2d Cir. 2008). 91 Id. at 161.

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G. When does a criminal restitution judgment/order expire?

In the pre-MVRA judicial landscape, there was a circuit split when determining the length of time before a restitution order expired.92 However, the MVRA clarified any ambiguities. 18 U.S.C. § 3613(b) states that “the liability to pay a fine shall terminate the later of 20 years from the entry of judgment or 20 years after the release from imprisonment of the person fined, or upon death of the person fined.” Accordingly, the financial penalties for the defendant last for the later of either twenty years after sentencing or twenty years after any period of incarceration, unless the defendant dies before the later period has expired. The MVRA was enacted in 1996, and it will be interesting to see if the courts find any circumstances in which a restitution order can be extended, starting in 2016. For the time being, the preference for a lump-sum payment, including payments from retirement accounts, is obvious.

As a related issue, the MVRA provides the court leeway in changing a restitution order. Section 3664(o) lists the methods in which a restitution order can be changed, including corrected under Rule 35 of the Federal Rules of Criminal Procedure, appealed and modified under section 3742, amended pursuant to section 3664(d)(5) upon discovery of new losses, or adjusted under section 3664(k) for a defendant’s changed circumstances.

III. PROTECTING AND UTILIZING SUBROGATION RIGHTS

A. Treatment of the Impairment of Subrogation Issues

1. What Constitutes the Impairment of an Insurer’s Subrogation Rights?

Certain actions taken by the insured can hinder the insurer’s subrogation rights against third parties, either completely destroying them or substantially impairing the insurer’s ability to enforce those

92 Catharine M. Goodwin, Imposition and Enforcement of Restitution,

FED. PROBATION 5 (June 2000).

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subrogation rights. The most common way an insured can do this is by settling with a third party and releasing him from all future liability for the claim, without reserving the subrogation rights of the insurer. In the Texas state case, Mendez v. Allstate Property & Casualty Insurance Co.,93 the insured, Mendez, was involved in an automobile accident and subsequently settled with the other driver, who was responsible for the crash. The settlement agreement included a release by Mendez discharging the other driver from any and all claims arising from the cause of action. After signing this release, Mendez filed a claim with his insurance provider, Allstate. Allstate denied the claim on the grounds that Mendez’s said actions had destroyed Allstate’s subrogation rights against the responsible driver. The court agreed, finding that Mendez’s release “extinguished Allstate’s subrogation rights” and was thus a material breach of the policy provisions.94

An insured’s failure to preserve evidence can also lead to the insurer’s subrogation rights being impaired. In a New York state case, Tropic Pollo I Corp. v. National Specialty Insurance,95 the insured was the victim of a fire; and it was unclear what actually caused the fire.96 Several attempts to organize an inspection with all interested parties—the insured, insurer, and potential subrogation targets—had to be postponed; after seven weeks, the insured had completely cleaned up the fire scene and replaced the damaged ductwork and fire suppression system without waiting any longer for the inspection.97 Because the insurer would be unable to meet its burden of proof in any future litigation against the potentially liable third parties due to the insured’s actions, the court found the insured had impaired the insurance company’s subrogation rights.98

When a surety is secured by collateral, an insured who impairs that collateral can find his insurer denying coverage for the claim. Impairment of collateral can be caused by the following:

93 231 S.W.3d 581 (Tex. Ct. App. 2007). 94 Id. at 583. 95 818 F. Supp. 2d 559 (E.D.N.Y. 2011). 96 Id. at 560. 97 Id. at 561. 98 Id. at 563.

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diminution in the value of the collateral resulting from the failure of the obligee to fulfill a duty with respect to the collateral, diminution in potential recovery from the collateral resulting from failure to obtain or maintain perfection of the security interest, release of the security interest in the collateral, and any loss or penalty resulting from improper disposition of the collateral.99

In F.D.I.C. v. Fidelity and Deposit Co. of Maryland,100 the Ninth Circuit granted summary judgment in favor of the bonding company claiming its obligation to pay the bond was nullified by the receiver’s actions in disposing of the insured’s collateral property for far less than its actual value. In that case, FDIC, as receiver for the insured, sought enforcement of a loan indemnifying the insured for losses caused by employee dishonesty.101 The FDIC had already sold property in which Fidelity had a security interest at public auction for $10,200.00. The actual value of the property was approximately $50 million. The insurer claimed, and the U.S. Ninth Circuit agreed, that FDIC’s selling of the property for so little, and without prior notice to Fidelity, substantially prejudiced Fidelity and exempted it from payment on the bond for that claim.102

Another example of impaired subrogation rights occurs where the insured allows the statute of limitations period to expire on a cause of action against a potentially liable third party while his claim with the insurer is still being evaluated.103 In Republic National Life Insurance Co. v. U.S. Fire Insurance Co.,104 the Texas state appellate court explicitly stated that, where the fidelity bond obligee failed to file suit against a liable third party within the statute of limitations period, the

99 RESTATEMENT (THIRD) OF SURETYSHIP & GUARANTY § 42 (1996). 100 132 F. App’x 139 (9th Cir. 2005). 101 Id. at 143. 102 Id. 103 See discussion supra Part III, Section A, Subpart 2, Subsection c. 104 589 S.W.2d 737, 742 (Tex. Civ. App. 1979), rev’d on other

grounds, 602 S.W.2d 527 (1980).

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insurer’s subrogation rights would be impaired; and the insured’s right of recovery against the insurer for that claim would be barred.105

2. Protecting the Insurer’s Subrogation Rights from Impairment

a. Contractual Provisions

While subrogation actions were traditionally based in equity, many insurance policies now contain provisions entitled “Transfer of Rights of Recovery Against Others to Us,” or similar provisions, in order to make subrogation a contractual right. Generally, such policy provisions require the insured not to impair the insurer’s rights of subrogation. Standard policy language includes the following: “You must transfer to us all your rights of recovery against any person or organization for any loss you sustained and for which we have paid or settled. You must also do everything necessary to secure those rights and do nothing after loss to impair them.”106

Often insurers rely on this type of policy language to claim that their obligation to pay under the policy is extinguished when their insured’s actions impair their subrogation rights and either refuse to pay the claim or demand reimbursement of already made payments. Courts have held impairment of subrogation rights to be a valid defense to an action for payment by the insured that has released or otherwise prejudiced his insurer’s rights.107

b. Identify Potential Targets and Options

Once an insurer has a claim filed against it, one of the insurer’s first responses should be to protect its subrogation rights. Generally, the insurer cannot proceed against a potentially liable third party until it has

105 589 S.W.2d at 742. 106 See ISO Form CR 00 21 07 02; ISO Form CR 00 23 05 06. 107 Tropic Pollo I Corp. v. National Specialty Ins., 818 F. Supp. 2d 559

(E.D.N.Y. 2011); Mendez v. Allstate Prop. & Cas. Ins. Co., 231 S.W.3d 581 (Tex. Ct. App. 2007); Stolaruk v. Cent. Nat’l Ins. Co. of Omaha, 522 N.W.2d 670, 673-74 (Mich. App. Ct. 1994); St. Louis Fed. Sav. & Loan Ass’n v. Fid. & Deposit Co. of Md., 654 F. Supp. 314 (E.D. Mo. 1987).

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paid the insured’s claim. However, the insurer should not neglect to look after its subrogation rights, as such neglect can lead to the impairment or destruction of the insurer’s right to recover the amount paid to the policyholder for which another party is responsible.

Because the insurer who has paid a covered claim is “stepping into the shoes” of the insured, its rights against a liable party are identical to those the insured possessed prior to subrogation, to the extent the losses were paid by the insurer.108 The insurer should meet immediately with the insured and ensure the company has a full understanding of the events that caused the loss. With this information, the insurer can examine the issue from the perspective of its insured, to determine what causes of action the insured might have and who might be liable to the insured for those damages covered under the policy. These tortfeasors are the insurer’s potential targets for a subrogated claim to recover any losses paid by the insurer.109

After identifying potential targets, another consideration is whether those tortfeasors are capable of paying a judgment against them. This research enables the insurer to determine whether an insured’s release of a party will actually impair its rights, or whether the effect will be negligible, as where the tortfeasor is effectively judgment-proof due to lack of resources.

c. Determine the Applicable Statutes of Limitations

The statute of limitations on a subrogated claim is identical to the statute of limitations on the underlying claim. Thus, the insurer is treated as if it were the insured when prosecuting the claim. Because statutes of limitations vary by jurisdiction, the insurer must evaluate each claim individually to determine what period is applicable. This is dependent on where the cause of action arose for the insured, because it

108 In re Avondale Gateway Ctr. Entitlement, L.L.C., CV10-1772-PHX-DGC, 2011 WL 1376997 (D. Ariz. 2011).

109 See Gary M. Case, Subrogation Rights and the Fidelity Insurer: How to Protect Them, and What to Do When They Have Been Prejudiced, at 6 (unpublished paper presented at Eighth Annual Northeast Surety and Fidelity Claims Conference, Iselin, N.J., Nov. 6-7, 1997), available at http://www.forcon.com/papers/nesfcc/1997/07.Case.pdf.

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is the insured’s claim. The statute of limitations will also toll against the insurer exactly as it did against the insured; the period does not restart for the insurer when the right becomes subrogated. Similarly, the doctrine of contra non valentem only applies to the principal and right holder; once the insured becomes aware of the loss, the statute of limitations begins, regardless of when the insurer is informed of any potential claim.

Thus, if the insured’s cause of action has prescribed before the claim even becomes subrogated, the insurer is left with no remedy against the third party. The insurer may, however, still have a right against the insured who allowed his third-party claim to lapse. In Republic National Life Insurance Co. v. U.S. Fire Insurance Co.,110 the Texas court stated in dicta that the insured’s right of recovery against the insurer would be barred if the insured had allowed his claim against a third-party tortfeasor to lapse due to failing to file suit within the applicable period.111

d. Evaluate Whether to Invoke the Impairment Defense

If an insured does execute a release of the tortfeasor or otherwise impair the insurer’s subrogation rights, the insurer may still have the option to refuse claim payment or pursue reimbursement from the insured itself for alienating the insurer’s subrogation right without authorization. Whether this defense will be successful is a fact-specific inquiry.

To prevail when using the impairment defense, most jurisdictions require the insurer to have been actually prejudiced by the insured’s settlement with the tortfeasor. The central issue is whether the insurer, but-for the insured’s release of the third party from liability, could have recovered from the third party for the losses paid to the insured.

Where the burden of proof lies with regard to proving that the insurer was or was not prejudiced varies by jurisdiction. Some courts

110 589 S.W.2d 737 (Tex. Civ. App. 1979), rev’d on other grounds, 602

S.W.2d 527 (1980). 111 589 S.W.2d at 742.

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have placed the burden on the insured to justify their release of the third-party tortfeasor by proving the lack of prejudice to the insurer.112 In Security National Bank of Kansas City v. Continental Insurance,113 for example, the United States District Court for the District of Kansas expressed skepticism that even proof that the release of a third-party tortfeasor without the consent of the insured would not prejudice the insured would bar the insurer’s substantial impairment defense.114 Even when the court assumed, arguendo, that lack of prejudice would preclude the defense, the court placed the burden on the insured to prove the lack of prejudice and found that this burden was not met even where the tortfeasor was in bankruptcy, where the insured showed no evidence of what happened to the tortfeasor’s remaining assets.115

Other courts have placed the burden on the insurer to show that it was actually prejudiced by the insured’s release.116 In the Ninth Circuit case of F.D.I.C. v. Fidelity and Deposit Co. of Maryland,117 a fidelity bond issuer claimed that it should not have to pay a policy claim due to the insured’s breaching the terms of the policy provisions by impairing the collateral. The Ninth Circuit held that California law and the terms of the bond, which stated “Insured shall do nothing after discovery of loss to prejudice [its] rights,” required the insurer to prove it had actually been prejudiced by the insured’s actions.118

Perhaps the most obvious instance of when an insurer would have been unable to recover whether or not the tortfeasor was released is when the tortfeasor has no assets with which to compensate the insurer. The release of a judgment-proof third party does not negatively change

112 Gibbs v. Hawaiian Eugenia Corp., 966 F.2d 101, 106 (2d Cir. 1992);

Sec. Nat’l Bank of Kansas City v. Continental Ins., 586 F. Supp. 139, 147 (D. Kan. 1982);

113 586 F. Supp. 139 (D. Kan. 1982). 114 Id. at 148. 115 Id. 116 F.D.I.C. v. Fid. & Deposit Co. of Md., 132 F. App’x 139, 142 (9th

Cir. 2005); Allied Mut. Ins. Co. v. Heiken, 675 N.W.2d 820, 829 (Iowa 2004). 117 132 F. App’x 139 (9th Cir. 2005). See discussion supra Part III,

Section A, Subpart 1. 118 132 F. App’x at 142.

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the insurer’s position, so an impairment defense would unlikely prevail in such a situation.119

Likewise, if only worthless claims are released by the settlement, then the insurer is not prejudiced because it would not have been able to recover on such claims anyway. In Gibbs v. Hawaiian Eugenia Corp.,120 the insured ship owner, Hawaiian, entered into a voyage charter party to carry cargo for Charters.121 Their charter party specified that Hawaiian would not be liable for nonarrival due to force majeure, if Hawaiian could prove to the satisfaction of the U.S. Agency for International Development,122 which was responsible for 90% of the payment to Hawaiian, that the vessel owner was without fault; Hawaiian’s underwriters had insisted upon the inclusion of this provision. Hawaiian’s ship and Charters’ cargo was then lost at sea after severe weather. Hawaiian was indemnified by their underwriters and then effected a settlement with Charters, releasing Charters from any potential claims regarding the lost cargo.123 The underwriters then sought to recover the amount paid under the policy, claiming Hawaiian’s release of Charters impaired their subrogation rights.124 The Second Circuit, however, noted that A.I.D.’s satisfaction that Hawaiian was without fault was a condition precedent for Charters’ liability. Because A.I.D. had provided no documentation supporting this, the condition precedent had not been met; therefore, Hawaiian had not released a valid claim. Because the only released claim was worthless, the court determined that the underwriters had not been prejudiced and were unable to recover the payment on Hawaiian’s claims.125

Where the insured and the released tortfeasor share the same insurer, some courts have found that the insurer has not been prejudiced.126 In Dupre v. Vidrine,127 a Louisiana case, the insured was

119 See Case, supra note 111, at 6. 120 966 F.2d 101 (2nd Cir. 1992). 121 Id. at 103. 122 Hereinafter A.I.D. 123 Id. at 104. 124 Id. at 105. 125 Id. at 107. 126 Dupre v. Vidrine, 261 So. 2d 288 (La. Ct. App. 1972); Moring v.

State Farm Mut. Auto. Ins. Co., 426 So. 2d 810 (Ala. 1982).

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involved in a motor accident and subsequently settled with and released the responsible driver, without reserving the insurer’s subrogation rights.128 When the insured filed a third-party demand against the insurer after being sued for medical expenses, the insurer asserted the impairment defense due to the release. The insured and the third-party tortfeasor both held policies from the same insurer, and the court held that the insurer had not been prejudiced, stating it “failed to see” how the insurer was prejudiced by being “deprived of a right of subrogation against themselves and their insured.”129

A release executed by the insured does not always release the third-party tortfeasor from liability for the subrogated claim; an exception exists when the tortfeasor has knowledge, before settling with the insured, that the insured had been or would be indemnified by an insurer who was subrogated to the insured’s rights.130 If the third-party tortfeasor has not actually been released from a subrogation claim, then the insurer has not been prejudiced; and its impairment of subrogation claim will be unsuccessful.

In the Iowa case of Allied Mutual Insurance Co. v. Heiken,131 the insurer, Allied, brought an action against its policyholders for settling with and releasing a negligent builder for a loss already indemnified by Allied. An attorney representing Allied had participated in the negotiations and informed the third-party tortfeasor of Allied’s subrogation rights.132 The court found that, because it was undisputed that the third-party tortfeasor had knowledge of Allied’s subrogation rights, the release signed by the insureds did not bar Allied from pursuing a claim against the third-party tortfeasor. Thus, because Allied had suffered no prejudice due to the release, it had no claim for impairment of subrogation claim against its policy holders.133

127 261 So. 2d 288 (La. Ct. App. 1972). 128 Id. at 290. 129 Id. 130 Allied Mut. Ins. Co. v. Heiken, 675 N.W.2d 820, 829 (Iowa 2004). 131 675 N.W.2d 810 (Iowa 2004). 132 Id. at 823. 133 Id. at 830.

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Although subrogation rights have now become contractually provided for in most insurance policies, the original basis for the impairment of subrogation defense has generally been based in principles of equity.134 Most courts have thus barred the defense when the insurer has acted unfairly or clearly against the interest of its insured, most commonly by denying coverage for the loss.135 In the Sixth Circuit case of Russell Gasket Co. v. Phoenix of Hartford Insurance Co.,136 the insurer originally denied the claim and did nothing after notice that the insured was pursuing a claim against the tortfeasor. When the insurer asserted the impairment defense at trial on the insurance policy, the Sixth Circuit denied the attempt, finding the insurer was estopped because “[r]ight from the beginning . . . it is plain that under no circumstances would it help [the insured] and that it never intended to protect and assist its insured.”137

In evaluating whether to assert an impairment of subrogation defense against its insured, the insurer should consider whether the equities are truly in its favor, that is, whether it has in fact been prejudiced by its insured’s actions and whether it has acted fairly and in the interest of its insured during the claims process. The insurer should also evaluate whether the insurer’s claims against third parties were actually released, the validity of those potential claims, and the ability of the third party to pay a judgment. Only if these requirements are positively met is the insurer’s impairment of subrogation defense likely to succeed.

e. Practical Tips for Handling these Cases

Although subrogation rights will generally not arise until after the policy claim has been paid, it is still advisable for the insurer to take

134 First Hays Banshares, Inc. v. Kan. Bankers Sur., 769 P.2d 1184 (Kan. 1989).

135 First Nat’l Bank of Louisville v. Lustig, 96 F.3d 1554 (5th Cir. 1996); Russell Gasket Co. v. Phoenix of Hartford Ins. Co., 512 F.2d 205 (6th Cir. 1976); Midland Bank & Trust v. Fid. & Deposit Co. of Md., 442 F. Supp. 960 (D.N.J. 1977); First Hays Banshares, Inc. v. Kan. Bankers Sur., 769 P.2d 1184 (Kan. 1989).

136 512 F.2d 205 (6th Cir. 1976). 137 Id. at 209 (emphasis in original).

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steps to protect its subrogation rights as soon as it becomes aware of a potential claim. The insurer should meet with its insured as early as possible to ascertain the facts of the situation, as well as working to keep communication lines open with the insured and the insured’s counsel to stay informed of any actions the insured intends to take that may either help or impair the insurer’s rights. This early information can aid the insurer in identifying any potentially liable third parties and instituting an action against such parties, where appropriate, before any applicable statute of limitations expires. In addition, prompt notification of the insurer’s subrogation rights to any potentially liable-third parties is one of the easiest and most effective ways an insurer can protect its rights from any release signed by its insured as in most jurisdictions such a release does not bar the insurer’s subrogation action if the tortfeasor knew of the insurer’s subrogation interest prior to executing the release.138

3. Recent Case Law

a. When Does the Insured’s Duty to Protect Subrogation Rights Arise?

A major, still-contentious question regarding the impairment of subrogation defense is when the duties of the insured to protect the insurer’s subrogation rights begin—before or after the claim is paid. Two recent cases on insurance law, both from New York, highlight the inconsistent interpretations that are still applied to seemingly standardized subrogation policy language.

In Gould Investors, L.P. v. Travelers Casualty & Surety Co. of America,139 the insurer, Travelers, argued that the insured impaired its subrogation rights by entering into settlements with third parties.140 Travelers asserted the impairment as a defense to the claim and declined

138 Allied Mut. Ins. Co. v. Heiken, 675 N.W.2d 820 (Iowa 2004). See discussion supra Part III, Section A, Subpart 2, Subsection b. See also Leader Nat’l Ins. Co. v. Torres, 779 P.2d 722, 724 (Wash. 1989) (recognizing that an “overwhelming majority of states” allows a subrogation claim where the tortfeasor knew of the insurer’s subrogation interest prior to the release).

139 83 A.D.3d 660 (N.Y. Sup. Ct. 2011). 140 See supra Part III, Section A, Subpart 2, Subsection a.

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to pay. The language of the subrogation provision mirrored that of the model ISO. Nonetheless, the New York appellate court found this provision to be ambiguous and determined that it precluded Travelers from asserting a defense of impairment of subrogation rights because its subrogation rights had not attached at the time the release was given.141 This decision has been criticized as going against the general consensus in the law that, although the insured’s rights are not transferred until payment, the insured has a duty to protect those rights beginning immediately upon loss.142 However, the New York state court’s language is very similar to that of previous cases in which the court barred the impairment defense relying on equity principles, indicating that some courts may still be grounding their interpretation of the defense in the equity doctrine rather than the provisions in the policy contract itself.143

Similarly, in Tropic Pollo I Corp. v. National Specialty Insurance Co., Inc.,144 the insurer asserted an impairment of subrogation defense after the insured executed a settlement and release with a potentially liable third party. Despite the policy language being nearly identical to that in Gould, the United States District Court for the Eastern District Court of New York found the language to be clear and unambiguous in this case. The court held that not impairing subrogation rights was a condition precedent under the policy for the insured to recover from its insurer.145 Because the insured failed to do so, it could not collect under the terms of the policy; and the insurer’s impairment defense was sustained.146

141 Id. 142 Adam P. Friedman, Fidelity Claims—The Year in Review, at 6-7

(unpublished paper presented at Twenty Second Annual Northeast Surety and Fidelity Claims Conference, Sept. 22-23, 2011), available at http://www. forcon.com/papers/ nesfcc/2011/13-Friedman.pdf.

143 See Midland Bank & Trust v. Fid. & Deposit Co. of Md., 442 F. Supp. 960, 973 (D.N.J. 1977) (rights of subrogation would not arise until after insured had been reimbursed for total loss).

144 818 F. Supp. 2d 559 (E.D.N.Y. 2011). 145 Id. at 562. 146 Id. at 563.

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IV. PROCEDURAL ISSUES THAT MAY AFFECT AN INSURER’S

PURSUIT OF ITS SUBROGATION RIGHTS

A. Treatment of Timing and Standing Issues in Subrogation Actions

1. Can an insurer obtain immediate standing to file a subrogation suit by making a partial payment?

Often the insurer will pay a claim that does not cover the entirety of its insured’s loss, either because the insured’s loss exceeds the policy limits, the damage includes both covered and not covered losses, or the insured has a policy deductible that he must pay before collecting from the insurer. Because subrogation relies on principles of equity, courts have generally recognized that the insurer is entitled to subrogation only so far as it has actually paid out in policy claims and that the insured retains his cause of action as to non-indemnified losses.147 Most jurisdictions also prioritize the insured’s right to be made whole for his losses over the insurer’s right to subrogation and will not allow the insurer to collect for his subrogated claims until after the insured has been fully indemnified,148 but states are divided on whether the insured’s right to complete recovery preclude the insurer from commencing a subrogation action where it has only partially indemnified the insured.

a. What Jurisdictions Allow Immediate Standing to File a Subrogation Suit by Making a Partial Payment?

When an insurer is only partially subrogated, states are divided on how to equitably allow both the insured and the insurer to be reimbursed, without hindering the rights of either. Several jurisdictions do not allow an insurer to proceed with a subrogation claim at all, until the insured has first been fully reimbursed. The rationale in these jurisdictions is that causes of action cannot be split; thus, the right to sue for the entire loss remains with the insured until his loss has been fully

147 See, e.g., Travelers Prop. Cas. Co. of Am. v. Kan. City Power &

Light, 568 F. Supp. 2d 1040 (W.D. Mo. 2008). 148 Id. at 1061.

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compensated.149 Jurisdictions that have upheld this theory include Arkansas,150 Delaware,151 Illinois,152 Indiana,153 Iowa,154 Kansas,155 Nebraska,156 New Mexico,157 North Carolina,158 North Dakota,159 Oklahoma,160 Virginia,161 and Wyoming.162 Although these jurisdictions do not normally allow an only partially subrogated insurer to proceed by itself against a third-party tortfeasor, some have recognized an exception for when the insured is unable or unwilling to pursue the action against the tortfeasor.163

Most other states have either not explicitly decided the issue or allow the insurer to at least proceed jointly with its insured to protect its subrogation rights. Jurisdictions that allow the partially subrogated insurer to proceed in its own name include Arizona,164 California,165

149 See Muskogee Title Co. v. First Nat’l Bank & Trust Co. of

Muskogee, 894 P.2d 1148, 1150 (Okla. Civ. App. 1995). 150 Washington Fire & Marine Ins. Co. v. Hammett, 377 S.W.2d 811,

812 (Ark. 1964). 151 Catalfano v. Higgins, 188 A.2d 357, 358 (Del. 1962). 152 Labella Winnetka, Inc. v. Gen. Cas. Ins. Co., 259 F.R.D. 143, 147

(N.D. Ill. 2009). 153 Willard v. Auto. Underwriters, Inc., 407 N.E.2d 1192, 1193 (Ind. Ct.

App. 1980). 154 Krapfl v. Farm Bureau Mut. Ins. Co., 548 N.W.2d 877 (Iowa 1996). 155 Hayes Sight & Sound, Inc. v. ONEOK, Inc., 136 P.3d 428, 439

(Kan. 2006). 156 Krause v. State Farm Mut. Auto. Ins. Co., 169 N.W.2d 601, 605 on

reh’g, 170 N.W.2d 882 (Neb. 1969). 157 Amica Mut. Ins. Co. v. Maloney, 903 P.2d 834, 838 (N.M. 1995). 158 S & N Freight Line, Inc. v. Bundy Truck Lines, Inc., 164 S.E.2d 89,

92 (N.C. Ct. App. 1968). 159 Torske v. Bunn-O-Matic Corp., 216 F.R.D. 475, 478 (D.N.D. 2003). 160 Muskogee Title Co. v. First Nat. Bank & Trust Co. of Muskogee,

894 P.2d 1148, 1150 (Okla. Civ. App. 1995). 161 Travelers Ins. Co. v. Riggs, 671 F.2d 810, 813 (4th Cir. 1982). 162 Iowa Nat’l Mut. Ins. Co. v. Huntley, 328 P.2d 569, 573 (Wyo.

1958). 163 See, e.g., Ellsaesser v. Mid-Continent Cas. Co., 403 P.2d 185 (Kan.

1965). 164 United P. Reliance Ins. Co. v. Kelley, 618 P.2d 257, 259 (Ariz. Ct.

App. 1980).

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Georgia,166 Louisiana,167 Massachusetts,168 Missouri,169 Montana,170 Nevada,171 New York,172 Ohio,173 Pennsylvania,174 Texas,175 and federal courts under the Federal Rules of Civil Procedure.176

2. Quia Timet and Exoneration Actions

Quia timet is an action in equity that courts have used to prevent wrongs before they occur where no legal remedy was available.177 Sureties have used the action to protect themselves before their Indemnity Agreements become enforceable against the principal.178 If a surety has a reasonable basis to believe that bonded contract proceeds are being used for expenses other than payments for the bonded project and that this use greatly increases the surety’s likelihood of loss, the surety may institute the quia timet action. The surety need not wait until it has

165 Hodge v. Kirkpatrick Dev., Inc., 30 Cal. Rptr. 3d 303, 310 (Ct. App.

2005). 166 Childers v. E. Foam Products, Inc., 94 F.R.D. 53, 57 (N.D. Ga.

1982). 167 S. Farm Bureau Cas. Ins. Co. v. Sonnier, 406 So. 2d 178, 180 (La.

1981). 168 Apthorp v. OneBeacon Ins. Group, LLC, 935 N.E.2d 365, 369

(Mass. Ct. App. 2010). 169 Holt v. Myers, 494 S.W.2d 430, 438 (Mo. Ct. App. 1973). 170 State ex rel. Nawd’s T.V. & Appliance Inc. v. Dist. Ct. of Thirteenth

Jud. Dist. In and For Yellowstone County, 543 P.2d 1336, 1338 (Mont. 1975). 171 Arguello v. Sunset Station, Inc., 252 P.3d 206, 208 (Nev. 2011). 172 In re September 11 Litig., 649 F. Supp. 2d 171, 178 (S.D.N.Y.

2009). 173 In re Shinew, 33 B.R. 588, 593 (Bankr. N.D. Ohio 1983). 174 State Farm Mut. Auto. Ins. Co. v. Ware’s Van Storage, 953 A.2d

568, 573 (Pa. Super. Ct. 2008). 175 Campbell v. Jefferson, 453 S.W.2d 336, 338 (Tex. Civ. App. 1970). 176 St. Paul Fire & Marine Ins. Co. v. Peoples Nat. Gas Co., 166

F. Supp. 11, 12 (W.D. Pa. 1958). 177 Shannon J. Briglia, Mike F. Pipkin, & David C. Olson, The Surety’s

Enforcement of Its Rights to Collateral from the Principal and the Indemnitors, in THE SURETY’S INDEMNITY AGREEMENT: LAW AND PRACTICE, 2D ED. 277, 279 (Marilyn Klinger, et al. eds., 2008).

178 Id.

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actually made bond payments and become subrogated to the claimants.179 Because quia timet is an equitable action, the available remedies are flexible.180 Some courts have ordered funds to be frozen or appointed receivers.181 Other courts have ordered contract funds to be paid directly to the bond claimants.182 The most frequent remedy imposed, however, is to require the principal to deposit collateral with the surety to cover any anticipated losses.183 Although quia timet allows a protective action in many cases where no remedy at law yet exists, the remedy is not available in all circumstances. A surety will still need to establish to the court’s satisfaction that the surety has a reasonable and objective basis to believe that bond liability is probable.184

Exoneration differs from quia timet primarily in the matter of timing; whereas quia timet is available as soon as the surety reasonably expects bond liability, exoneration is only available after the principal has defaulted.185 Exoneration is the surety’s right to compel the principal to discharge its obligation to the bond claimants, so that the surety is not forced to pay the obligation instead.186 The surety need only prove that it

179 Id. at 280. 180 David J. Krebbs, Sureties’ Equitable Remedies: The Writ of Quia

Timet and Injunctive Relief (unpublished paper presented at Ninth Annual Southern Surety and Fidelity Claims Conference, Atlanta, Georgia, Apr. 23-24, 1998), available at http://www.forcon.com/papers/ssfcc/1998/09Krebs.pdf.

181 Id. 182 See, e.g., Fid. & Deposit Co. of Md. v. McClintic-Marshall Corp.,

171 A. 382 (N.J. 1934). 183 Milwaukie Constr. Co. v. Glenn Falls Ins. Co., 367 F.2d 964 (9th

Cir. 1966); Firemen’s Ins. Co. of Newark, N.J. v. Keating, 753 F. Supp. 1146 (S.D.N.Y. 1990); Northwestern Nat’l Ins. Co. of Milwaukee v. Alberts, 741 F. Supp. 424 (S.D.N.Y. 1990), rev’d on other grounds, 937 F.2d 77 (2d Cir. 1991).

184 Briglia, et al., supra note 177, at 283. See, e.g., Transamerica Premier Ins. Co. v. Calvary Constr. Inc., 552 So. 2d 225, 226-27 (Fla. Dist. Ct. App. 1989).

185 Briglia, et al., supra note 177, at 283. 186 Id.

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is liable, that the payment is currently due to the bond claimant, and that the ultimate obligation to pay the debt is the principal’s.187

3. Constructive Trusts

Constructive trusts are a way that courts can impose equity when one person holds property that rightfully belongs to another. A constructive trust compels “one who unfairly holds a property interest to convey that interest to another to whom it justly belongs.”188 There are many circumstances in which the imposition of a constructive trust can protect the insurer’s subrogation rights where the insurer is unable to pursue a direct action against the ultimately liable party, often due to timing or standing constraints.

a. Trusts Imposed on Insured’s Recovery

Many states do not allow an insured to receive “double recovery” for a loss, keeping the payment for a loss from a third-party tortfeasor after collecting for the same loss from its insurer.189 To prevent this in jurisdictions that do not allow causes of action to be split between the insured and his partially subrogated insurer,190 courts often consider the insured who recovers all of a partially indemnified loss to be a “trustee for the insurer (to the extent of the loss paid by the insurer) in the recovery secured by it.”191

These situations create a constructive trust, in which the insured is tasked with administering the entire amount recovered and reimbursing the insurer. Because the insured is not entitled to claims for which he has already been compensated, the trust is imposed “to prevent the injustice that would otherwise result by the inability of the insurer to

187 Id.; see Schirm v. Auclair, 597 F. Supp. 202 (D. Conn. 1984). 188 THE LAW OF TRUSTS AND TRUSTEES § 471 (2012). 189 Allied Mut. Ins. Co. v. Heiken, 675 N.W.2d 820, 828 (Iowa 2004). 190 See discussion supra Part IV, Section A, Subpart 1, Subsection a. 191 Krapfl v. Farm Bureau Mut. Ins. Co., 548 N.W.2d 877, 879 (Iowa

1996). See also Firemen’s Ins. Co. v. Bremner, 25 F.2d 75, 76 (8th Cir. 1928); Krause v. State Farm Mut. Auto. Ins. Co., 169 N.W.2d 601, 605 on reh’g, 170 N.W.2d 882 (1969); McGeorge Contracting Co. v. Mizell, 226 S.W.2d 566 (Ark. 1950).

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independently pursue its claim.”192 Because the partially subrogated insurer cannot, in these jurisdictions, pursue its own action against the liable third party, the constructive trust protects the insurer from losing its right to recover entirely, by protecting the funds from any improper disbursement by the insured.

b. Trusts Imposed on Wrongdoer’s Assets

An equitable trust can also be imposed on a wrongdoer’s assets for a civil judgment. Such trusts are not available in all instances where a tortfeasor is liable for a judgment, but only where the wrongdoer has obtained another’s property through fraudulent or unlawful means.193 In the case of Whitefish Credit Union Ass’n v. Sammons,194 a default judgment was rendered in favor of a credit union against its former employee, who had embezzled hundreds of thousands of dollars from the credit union. The credit union had been partially indemnified for the loss by its fidelity insurer, so the court imposed the trust on behalf of both the credit union and its partial subrogee, the fidelity insurer. The trust prevented the employee from disposing of, transferring, or encumbering any of her assets without prior approval by the court, until the entire judgment was satisfied, increasing the likelihood of recovery for both the insurer and its insured.195

c. Trusts Imposed on Bonded Contract Funds

Contract bond payments may also be held in a constructive trust; this can aid a surety in mitigating losses caused by default of a principal.

192 Allied Mut. Ins. Co. v. Heiken, 675 N.W.2d 820, 828 (Iowa 2004).

For a discussion of priority issues when the recovery does not compensate the insured’s entire losses, see Susan Evans Jones, Subrogation Disputes Between the Fidelity Carrier and its Insured: Impairment and Priority Issues, (unpublished paper presented at Twenty First Annual Northeast Surety and Fidelity Claims Conference, Sept. 23-24, 2010) available at http://www.forcon.com/papers/nesfcc/2010/15-Evans-Jones.pdf.

193 THE LAW OF TRUSTS AND TRUSTEES § 471 (2012). 194 No. DV 11-1363C (D. Mo. 2012). 195 Id.

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Many states have statutes that either implicitly or explicitly196 create an equitable trust over contract funds in favor of subcontractors or suppliers who provide services or materials for the contract work. Where the trust is imposed by implication, the statute usually either imposes criminal liability or penalty for the misappropriation of contract funds, or the statute creates a lien in favor of the subcontractors and suppliers on the contract payments.197 Whether such statutes create a constructive trust varies among the states and can only be determined by a state-specific analysis of controlling state jurisprudence.198

Where such trusts are created by statute, the surety can argue that trust proceeds should not form part of the debtor’s bankruptcy estate. State law governs whether contract trust funds constitute part of the debtor’s estate, with some jurisdictions holding that trust funds should be included as part of the estate, though subject to an equitable lien on

196 See ARIZ. REV. STAT. ANN. § 33-1005; COLO. REV. STAT. § 38-22-

127; DEL. CODE ANN. 6 § 3502; 770 ILL. COMP. STAT. ANN. 60/21.02; MD. CODE ANN., REAL PROP. § 9-201; MICH. COMP. LAWS ANN. § 570.151; N.J. STAT. ANN. § 2A:44-148; N.J. STAT. ANN. § 2A:29A-1 -4; N.Y. LIEN LAW § 70-79; OKLA. STAT. TIT. 42, § 152; TEX. PROP. CODE ANN. § 162.

197 Michael F. Burkhardt & Jeffrey S. Price, Trusts on Contract Balances (unpublished paper presented at Twenty First Annual Southern Surety and Fidelity Claims Conference, Charleston, South Carolina, Apr. 15-16, 2010) available at http://www.forcon.com/papers/ssfcc/2010/04.%20Price.pdf. Not every state that has such statutes has found that a constructive trust is imposed. See In re Turner, No. 10–10454, 2011 WL 5593116 (M.D. La. 2011) (holding LA. REV. STAT. ANN. § 14:202 did not create a trust relationship); In re Null’s Serv., 109 B.R. 301 (W.D. Tenn. 1990) (holding TENN. CODE ANN. § 66-11-138 created neither an express nor constructive trust); In re Sigler, 196 B.R. 762 (Bankr. W.D. Ky. 1996) (holding KY. REV. STAT. ANN. § 376.070 did not create a trust relationship).

198 Burkhardt & Price, supra note 197, at 10. See, e.g., State v. Reps, 223 N.W.2d 780 (Minn. 1974) (Minnesota statute imposing criminal liability for nonpayment of funds does create a constructive trust); In re Ecker, 400 B.R. 669, 672 (Bankr. E.D. Wis. 2009) (Wisconsin “Theft by contractor” statute creates trust). But see In re Null’s Serv., 109 B.R. 301 (W.D. Tenn. 1990) (Tennessee statute imposing criminal penalty for misuse of construction payments did not create a trust).

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behalf of subcontractors, suppliers, and sureties,199 and some holding that the trust should be excluded from the bankruptcy estate entirely.200 If the surety can have contract funds excluded from the estate, those funds will not be subject to the automatic stay or any pro rata distributions, but will instead be immediately available solely for payment of bond claims.201 This can greatly decrease the surety’s both immediate and overall outlays under the bond contract. Even where the trust funds are considered part of the estate, the surety can use the trust to prevent the debtor from discharging the debt in bankruptcy because any use of contract trust funds other than for the express purpose of the trust may constitute defalcation under section 523(a)(4) of the Bankruptcy Code, which renders a debt nondischargeable.202

V. Treatment of Bankruptcy Considerations in Subrogation Actions

A. The Bankruptcy Code Does Not Defeat a Claim of Equitable Subrogation

When a debtor files for bankruptcy protection under the United States Bankruptcy Code, the debtor’s goal is to discharge or minimize the debts that he currently owes. Even if the debtor is successful, the surety’s obligation on the same debt is generally not discharged; and the surety will be expected to honor his obligation and pay its principal’s creditors for the debt.

Under normal circumstances, the surety would then be subrogated to the creditor’s rights against the principal, allowing the surety to pursue a claim against the principal for indemnification for the debt. However, if the principal’s debt has been discharged in the

199 In re Maxon Eng’g Servs., Inc., 332 B.R. 495, 500 (Bankr. P.R. 2005); In re Glover, 30 B.R. 873 (Bankr. W.D. Ky. 1983).

200 In re B.I. Fin. Servs. Group, Inc., 854 F.2d 351, 354 (9th Cir. 1988) (applying California law).

201 See discussion infra Part V, Section B, Subpart 4, Subsection f. 202 See, e.g., In re Fox, 357 B.R. 770 (Bankr. E.D. Ark. 2006); In re

Smith, 238 B.R. 664 (Bankr. W.D. Ky. 1999). See discussion infra Part V, Section A, Subpart 3, Subsection d. for discussion of the dischargeability of debts in bankruptcy proceedings.

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bankruptcy proceedings, a surety may be left with no available means for reimbursement of the debt. Thus, a surety must be alert, even before and especially after a principal’s filing for bankruptcy protection, to protect its subrogation rights.

Section 509 of the Bankruptcy Code specifically allows for subrogation claims, providing: “Except as provided in subsection (b) or (c) of this section, an entity that is liable with the debtor on, or that has secured, a claim of a creditor against the debtor, and that pays such claim, is subrogated to the rights of such creditor to the extent of such payment.”203 Although subrogation arises from equitable principles, courts have held that the subrogation rights provided in the Code are non-exclusive and are in addition to equitable subrogation remedies.204 These courts note that equitable subrogation is traditionally only available for claims that have been fully paid by another, whereas the statutory language expressly permits partial subrogation where a debt has only been partially paid.205

B. Contractual Subrogation in Bankruptcy

1. Indemnity Governed by Private Contract and State Law, Not Federal Bankruptcy Law

In Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co.,206 the United States Supreme Court determined that private parties are free to contract for rights not explicitly granted in the Bankruptcy Code. In that case, Travelers had issued surety bonds on behalf of Pacific Gas. The indemnity agreement between Travelers and Pacific Gas provided that Pacific Gas was responsible for any loss suffered by Travelers in connection with the surety bonds, including attorney’s fees incurred by Travelers in pursuing, protecting, or litigating its rights under the bond. When Pacific Gas filed for bankruptcy

203 11 U.S.C. § 509. 204 See In re Missionary Baptist Found. of America, 667 F.2d 1244,

1246 (5th Cir. 1982); In re Zoglam, 78 B.R. 213, 214 (Bankr. W.D. Wis. 1987). 205 In re Northview Motors, Inc., 202 B.R. 389, 401 (Bankr. W.D. Pa.

1996). 206 549 U.S. 443 (2007).

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protection, Travelers intervened to protect its contractual and subrogation rights, even though Pacific Gas had not defaulted on its surety bond obligations, and then filed a claim for attorney’s fees under the contract provisions.207 The lower courts held that contractual attorney’s fees could not be collected if the issues being litigated involved only questions of federal bankruptcy law.208 The Supreme Court reversed, holding that “state law governs the substance of claims.”209 Thus, a surety’s right to pursue a contractual or state law claim will not change merely for involving only questions of federal bankruptcy law, unless subject to qualifying or contrary provisions in the Bankruptcy Code.

2. Can a Surety be Held Liable for Pre-Petition Payments made by its Principal?

a. Preference Actions

The Bankruptcy Code provides for rescission of payments made by a debtor prior to its declaring bankruptcy in certain circumstances, even when payment to the creditor was proper and not fraudulent.210 This allows the bankruptcy trustee (or debtor in possession) to recover assets and more equitably distribute assets under the bankruptcy proceeding. Most preference actions involve the trustee proceeding directly against the creditor who received the payment. In the case of a debt guaranteed by a surety, often termed “indirect preference actions,” the trustee may proceed against the surety directly for payments to creditors for the guaranteed debt that were paid before unguaranteed debts.211

In an indirect preference action, the trustee has the burden of proof for establishing:

207 Id. at 446. 208 Id. at 449. 209 Id. at 450. 210 11 U.S.C. § 547. 211 Newbery Corp. v. Fireman’s Fund Ins. Co., 106 B.R. 186, 187 (D.

Ariz. 1989) (“[T]he estate may proceed directly against a surety, instead of circuitously recouping the preference from the creditor, forcing the creditor to proceed against the surety and then waiting for the surety to assert a claim against the estate for reimbursement.”).

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(1) A transfer was made;

(2) The transfer was the property of the debtor;

(3) The transfer was to or for the benefit of a creditor;

(4) The transfer was for or on account of an antecedent debt owed by the debtor before the transfer was made;

(5) The transfer was made while the debtor was insolvent;

(6) The transfer was made during the ninety days immediately preceding the commencement of the bankruptcy case. If the transfer was made to an insider, the transfer may be avoided for the period one year prior to the commencement of the bankruptcy case; and

(7) The transfer enabled the creditor, to or for whose benefit it was made, to receive a greater percentage of its claim than it would receive under the distributive provisions of the Bankruptcy Code. In other words, the creditor must have received more than it would have received if the payments had not been made and the creditor instead received what it would in a Chapter 7 liquidation.212

b. Defenses

Because the trustee must prove a preference payment was made under section 509, a surety may successfully disprove any element of the trustee’s prima facia case to bar the preference action.213 Section 547(c) also provides several affirmative defenses for a surety faced with an indirect preference action, among them:

212 11 U.S.C. § 547(b); Robert J. Berens, Bankruptcy: Can a Surety Be

Held Liable for the Prepetition Payments Made by Its Principal? in NORTON’S

ANNUAL SURVEY OF BANKRUPTCY LAW 209, 212 (1995-96 ed.). 213 See, Berens, supra note 212, at 220.

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(1) The payment was intended by all parties to be a contemporaneous exchange for new value, and was, in fact, substantially contemporaneous.

(2) The payment was of a debt made and incurred in the ordinary course of both the debtor’s and the transferee’s business and made according to ordinary business terms.

(3) An advance of new unsecured credit to the debtor after the payment is made by the debtor.

(4) The fixing of a statutory lien that is not avoidable under section 545. Payment in satisfaction of a perfected statutory lien that is fully secured may not be a preferential transfer.214

When the principal pays a creditor on a bonded job, the surety is released from its contingent liability to pay that debt under its bonds; thus, the surety indirectly benefits. This is the rationale behind indirect preference actions. However, at the same time the surety is released from its bond to pay that creditor, the creditor releases its equitable lien against contract funds the principal was entitled to receive, in the amount of the payment to the creditor.215 Some courts have held that the automatic release of this equitable lien constitutes “new value” to the debtor.

In the Ninth Circuit case of In re: E.R. Fegert, Inc.,216 a preference action was brought against the debtor’s surety, for payments made to subcontractors that had an equitable lien in the work done. If the contractors had been paid by the surety, then the surety would have been subrogated to the lien and would have also had a senior preference for payment. The Ninth Circuit held that release of a security interest in the form of an equitable lien “constitutes the ‘new value’ that is

214 11 U.S.C. § 547(c). Berens, supra note 212, at 220. 215 Robert J. Berens, Bankruptcy Issues that a Surety Should Consider,

Both Prepetition and Postpetition (unpublished paper), available at http://www.mbwlaw.com/articles/surety-bankruptcy.htm.

216 887 F.2d 955 (9th Cir. 1989).

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‘contemporaneously exchanged,’” and thus the preference action was barred against either the sub-contractors or the surety by section 547(c)(1) of the Bankruptcy Code.217

A recent case from the Fourth Circuit, however, could likely create problems for a surety asserting the “new value” defense. Although not expressly rejecting the reasoning in Fegert, the Fourth Circuit in United Rentals, Inc. v. Angell218 concluded that a surety was not able to claim contemporaneous exchange for “new value” where the subcontractor never attempted to collect on the bond because “the Surety never obtained any lien that it could release.”219

A similar affirmative defense is the “subsequent advance of new value” defense. This defense protects creditors who, after receiving a preferential payment, extend new unsecured credit to the principal.220 In the case of In re IRFM, Inc.,221 the Ninth Circuit compared alternating preferential payments to a vendor and the vendor’s extension of new credit to the principal within the ninety days before the principal filed for bankruptcy and offset the amount of the avoidable payments by the amount of new credit extended.222

To use this defense, the surety should track the preferential payments and subsequent advances made by each individual creditor. Because the surety is subrogated to the creditor’s right and can only avoid rescission of a preferential payment to the same extent as each creditor would be able to, it is important to analyze the payments and subsequent extensions of credit on a vendor-by-vendor basis.223

The Bankruptcy Code also provides a defense in the case of payments made in what is commonly termed the “ordinary course of

217 Id. at 958 (9th Cir. 1989). See also In re JWJ Contracting Co., Inc., 371 F.3d 1079 (9th Cir. 2004).

218 592 F.3d 525 (4th Cir. 2010). 219 Id. at 532. 220 11 U.S.C. § 547(c)(4). Berens, supra note 212, at 224. 221 52 F.3d 228 (9th Cir. 1995). 222 Id. 223 Berens, supra note 212, at 227. Berens suggests creating a

spreadsheet.

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business.” Section 547(c)(2) makes unrescindable payments “made in the ordinary course of business or financial affairs of the debtor and the transferee; or made according to ordinary business terms.” Prior to the 2005 major overhaul of the Bankruptcy Code, payments would have to meet both qualifications to avoid a preference action; the slight change of “and” to “or” in the statute greatly expanded the defense. Now, for example, a payment to a subcontractor made late, but pursuant to a “pay when paid” clause, should be safe from a preference action if the subcontractor (or surety) can prove that the payment was ordinary between the parties, whereas before 2005 the payment would likely have been avoided because ordinary business terms require such payments to be timely.224

3. Pre-Petition Issues that a Surety Should Consider

A surety can take some practical steps before its principal has filed for bankruptcy protection to protect its subrogation interests in a bankruptcy proceeding.

a. Filing the General Indemnity Agreement

When a surety becomes aware of potential financial problems with its principal, one way to protect itself in the event of a future bankruptcy proceeding is to file the general indemnity agreement it has with the principal with the secretary of state. The Agreement can typically be filed as a UCC-1 Financing Statement, which can elevate the surety’s status to that of a secured creditor.225 Not only can obtaining liens potentially provide a larger recovery than would be possible for the surety as an unsecured creditor, but also liens may entitle the holder to recover interest and attorney’s fees.226 Filing these liens should be done as soon as possible once the surety becomes aware that bankruptcy or insolvency could be on the horizon because the liens would be

224 Berens, supra note 215, at 24. 225 Berens, supra note 215, at 2-3. 226 See 11 U.S.C. §§ 506(b), 1129 (b)(2)(A). See also Berens, supra

note 215, at 3.

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rescindable as a preference action if given less than ninety days prior to the principal’s filing for bankruptcy.227

b. Sending a “Hold Funds” letter

When a surety is notified of claims from the principal’s subcontractors or suppliers against the bond payment, it is in its interest to promptly notify the obligee of these claims and of any payments the surety has made that would create subrogation rights in the funds held by the obligee.228

Sending a Hold Funds letter to the obligee protects the funds from being distributed to the principal and then used by the principal for an improper purpose, such as hiring a law firm to handle its Chapter 11 reorganization.229 Once the bond funds have been paid to and used by the principal improperly, the surety often has little recourse to recover the bulk of that loss.

c. Filing for Involuntary Bankruptcy

A principal’s declaring bankruptcy is usually considered to be a poor outcome by its surety, so it would seem counterintuitive for a surety to contemplate initiating such a proceeding. There are certain circumstances, however, where it may be in the surety’s best interest to do so, specifically, where an increasingly insolvent principal is using significant amounts of bonded funds to pay non-bond debts instead of paying bond claimants.230 Initiating the bankruptcy proceeding against its principal can allow those improperly disbursed funds to be rescinded through preference actions and can help mitigate the surety’s future losses.231 Although a drastic remedy, when faced with a principal that is unlikely to recover from its increasing insolvency through non-bond

227 11 U.S.C. § 547(b). 228 If the principal has already filed for bankruptcy, a Hold Funds letter

may violate the Automatic Stay. See infra Part V, Section B, Subpart 4, subsection f. for discussion and recommendations.

229 Berens, supra note 215, at 4. 230 Berens supra note 215, at 21. 231 For a discussion of when and how to file a petition for involuntary

bankruptcy against a principal, see Berens supra note 215, at 22.

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disbursements, involuntary bankruptcy may be the surety’s best option to preserve at least some of the principal’s assets for offset against the surety’s bond obligations.232

d. Bankruptcy Filing May Toll the Bond Limitations Period

Even if its principal seems in no danger of default or insolvency, the surety is well advised to also stay informed about the bankruptcy status of other parties to the bond agreement, the obligee, and potential bond claimants. In the case of a principal’s default, the statute of limitations during which a party can bring an action against the surety for performance of the principal’s obligation is unaffected because the Bankruptcy Code only extends the period for filing against the debtor, not against any other party liable for the same debt.233 However, if another party, such as a bond claimant or the obligee, is the debtor, the Bankruptcy Code may allow the limitations period to toll on that party’s behalf, if the period did not expire before the party filed for bankruptcy. Section 108(a) allows a debtor to commence an action until the later of either the end of the limitations period, including any suspension, or two years after the order for relief.234 Section 108(b) extends the limitations period to “file any pleading, demand, notice, or proof of claim or loss, cure a default, or perform any other similar act” to the later of either the end of the period, including any suspensions, or sixty days after the order for relief.

The surety is much less likely to be involved in and aware of the bankruptcy proceedings of the obligee or a bond claimant than it is in the bankruptcy of its principal. This could result in a previously unexpected claim arising later than the surety believed allowable under the prescriptive period. To protect against this, the surety should investigate

232 Id. 233 11 U.S.C. § 108(c). See, e.g., U.S. ex rel. Am. Bank v. C.I.T.

Constr., Inc. of Tex., 944 F.2d 253 (5th Cir. 1992); Cumberland Metals, Inc. v. Kentucky Ins. Guar. Ass’n, 801 S.W.2d 339 (Ky. Ct. App. 1990).

234 The “order for relief” in voluntary bankruptcy is when the bankruptcy petition is filed; in involuntary bankruptcy it is the date the party is adjudicated to be a “debtor.” Berens, supra note 215, at 20.

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the possibility of “extended claims” arising before agreeing to the final disbursement of contract funds or the release of any collateral to the principal.235

4. Issues that a Surety Should Consider After Its Principal Enters Bankruptcy Proceedings

Once a principal files for bankruptcy protection, the surety still has several options available to it that may mitigate any bond losses. It is important for the surety to stay informed on the status of the proceedings, especially regarding any deadlines for filing motions and other actions, so as to not inadvertently prejudice any of its means of recovery.

a. Notice of Appearance and Request for Notice

Filing a Notice of Appearance and Request for Notice should be done within the first days after the principal’s bankruptcy filing. This ensures that the debtor’s attorney knows who is representing the surety and that the surety’s counsel is added to the master mailing list for the proceedings. Many important notices and deadlines regarding the proceeding will be sent out through this list.236

b. First Meeting of Creditors

The surety should have a representative attend the first meeting of creditors. This is the surety’s first opportunity to gain information about its standing and that of the other creditors. Creditors are able to ask the debtor a limited number of questions under oath. A surety would be likely to inquire about issues such as payments of bonded contract proceeds, signatures on the indemnity agreement, critical issues with bonded projects, and the events that led to the bankruptcy filing.237

235 Berens, supra note 215, at 20. 236 See, e.g., FED. R. BANKR. P. 2002. 237 Berens, supra note 215, at 8.

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c. Objections to Claimed Exemptions

The debtor is allowed to claim certain assets as exempt from the bankruptcy proceedings and thus not available to satisfy the debtor’s obligations. The creditor has thirty days after the first meeting of creditors to file any objections to the debtor’s list of claimed exemptions.238 Any objections not made within this time, or within thirty days of an amendment to the debtor’s schedule of exemptions, are deemed waived.239

d. Objections to Dischargeability of Debt

A bankruptcy proceeding allows for the discharge of many debts, which then become uncollectable by the surety.240 Prior to this release being granted, a surety has the opportunity to object to the discharge of the principal’s obligations under the Indemnity Agreement. The surety has sixty days from the first meeting of creditors to file a complaint to determine nondischargeability of the debt, for debts based on fraud, misleading financial statements, embezzlement, and breach of fiduciary duty.241

Section 523(a)(2) provides that debts that are incurred through “false pretenses, a false representation or actual fraud” are nondischargeable, so long as the statements are not regarding the financial condition of the debtor. Section 523(a)(2)(B) makes a debt incurred by providing the surety with an intentionally false financial statement nondischargeable, so long as the surety’s reliance on the statement was “reasonable.” Debts for “for fraud or defalcation while acting in a fiduciary capacity” are also exempt from discharge.242 Thus,

238 FED. R. BANKR. P. 4003(b). 239 Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). 240 11 U.S.C. § 727 & 1141(d)(1). 241 FED. R. BANKR. P. 4007(c). Prior to the 2005 Bankruptcy Code

Revisions, a Chapter 13 debtor could discharge such debts in what was termed the “super discharge.” Berens, supra note 215, at 23.

242 11 U.S.C. § 523(a)(4).

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if a principal misappropriates bond funds for an improper purpose, the debt may be nondischargeable.243

Although filing a complaint for nondischargeability may seem pointless in some cases, as where the principal and indemnitors have virtually no current assets, the possibility of the surety’s claim surviving may prompt the principal and indemnitors to cooperate in the surety’s completion of a bonded project or lead to more favorable settlements or reorganization treatment.244

e. Preparing Proof of Claims and the Issue of Unliquidated Claims

After the meeting of creditors, a creditor has ninety days to file his proof of claim, which must contain a liquidated amount owed.245 This can pose a conundrum for the surety, which often does not know the proper amount of the claim because bond claims remain pending.

The surety in this situation should list the penal sum, or maximum possible amount payable, under all its surety bonds as its amount claimed. The surety should ignore all other possible sources of recovery and analyze its remaining exposure under each of its bonds, including the currently liquidated portion of the claim.246 The proof of claim can later be amended to reduce the claimed amount, once the surety ascertains the exact amount of its losses.247 Although the trustee

243 Berens, supra note 215, at 10. 244 Id. 245 FED. R. BANKR. P. 4003(b). For considerations regarding the timing

of filing a proof of claim, see discussion infra Part V, Section B, Subpart 4, subsection h. 2.

246 Robert F. Carney, Reimbursement and Subrogation Rights under the Bankruptcy Code and the Surety’s Proof of Claim, 5 (unpublished paper presented at Seventh Annual Northeast Surety and Fidelity Claims Conference, Iselin, N.J., Oct. 24-25, 1996), available at http://www.forcon.com/ papers/nesfcc/1996/09.Carney.pdf.

247 In re Enron Corp., 328 B.R. 75 (Bankr. S.D.N.Y. 2005).

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can object to the amount of the claim, this typically does not occur until much later in the case.248

When characterizing its claim, the surety should not refer to the General Agreement of Indemnity as providing the source for its claim; the surety should specifically mention its subrogation rights in the proof of claim and its intention to preserve and assert those rights.249 A creditor may pursue a claim for either reimbursement or contribution or a claim for subrogation, but not both.250 Thus, if a surety files a proof of claim asserting only reimbursement rights, such as those under the General Agreement of Indemnity, the surety can be deemed to have elected its remedy and opted to pursue reimbursement rights, thereby effectively waiving any subrogation rights it might have.251

f. Action to Protect Bonded Contract Funds

The Bankruptcy Code provides that filing a petition for bankruptcy protection operates as a stay against creditors, including a surety, for many types of actions.252 There are, however, certain actions that a surety may take to protect bonded contract proceeds despite this restriction.

If the surety has failed to send a prepetition hold funds letter to the obligee for bond payments, the automatic stay likely prevents the surety from doing so after the principal files for bankruptcy.253 A carefully worded notice to the obligee informing the obligee of the situation and the surety’s position after an automatic stay has been issued, however, has been permitted. In the Ohio bankruptcy proceeding of In re Hughes-Bechtol, Inc.,254 a surety sent letters to the bond obligees that merely advised them that the surety had paid bond claims that had been asserted against the principal and stated the surety’s opinion that it was entitled to the bond proceeds, avoiding any demand for the funds or

248 Berens, supra note 215, at 9. 249 Carney, supra note 246, at 5. 250 In re Richardson, 193 B.R. 378, 380. 251 Carney, supra note 246, at 15. 252 11 U.S.C. § 362. 253 11 U.S.C. § 362(c). Berens, supra note 215, at 12. 254 117 B.R. 890 (Bankr. S.D. Ohio 1990).

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direction regarding how they ought to be paid. Although the principal complained that the letter violated the automatic stay, the bankruptcy court found the letter to be primarily informational in nature and not a violation of the stay.255 Practically, however, this information is often enough to prevent the obligee from dispersing bond funds to the principal until given direction by the bankruptcy court.256

The surety should carefully avoid making any demands for funds or declarations of default by the principal if sending such a notice to the obligee, as a violation of the automatic stay may result in losing rights in the bankruptcy proceeding or damages being awarded against the surety.257

When bond proceeds in which the surety has rights have been deemed the property of the bankrupt debtor’s estate, the funds are referred to as the “cash collateral” of the surety. The trustee is required to keep such funds separate from the debtor’s general assets and may not use any such funds without either the consent of the surety or authorization by the court after a hearing.258 The surety should endeavor to ensure that these requirements are followed, by notifying the debtor, as soon after the petition is filed as possible, that the surety does not consent to the use of bonded contract funds.259

If, after a hearing, the court decides to allow the debtor to use the bonded proceeds, the surety is still entitled to “adequate protection” of the surety’s cash collateral.260 The surety should suggest such forms of adequate protection as (1) limiting the disbursement of funds to only expenses required to keep the bonded contract going;261 (2) permitting the surety to control the principal’s payments of contract expenditures to

255 Id. See also In re United States Elec., Inc., 123 B.R. 262 (Bankr.

S.D. Ohio 1990); Merchants Bonding Co. v. Pima County, 860 P.2d 510 (Ariz. Ct. App. 1993).

256 Berens, supra note 215, at 12. 257 Berens, supra note 215, at 12. See In re Carroll, 903 F.2d 1266 (9th

Cir. 1990); 11 U.S.C. § 362(h). 258 11 U.S.C. §§ 363(c)(4) & (c)(2). 259 Berens, supra note 215, at 12. 260 11 U.S.C. § 361. 261 In re Ram Constr. Co., Inc., 32 B.R. 758 (Bankr. W.D. Pa. 1983).

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ensure they were going only to approved purposes; (3) providing an accounting for each project to review income and expenses; (4) limiting salary payments to the debtor’s stockholders, officers, or their relatives; and (5) not allowing payment for expenses not necessary to the ongoing bonded projects.262

g. Right to Vote on a Chapter 11 Plan of Reorganization

A recent ruling from the United States District Court for the District of Arizona may significantly impact a subrogor’s voting rights in a Chapter 11 plan of reorganization, even without the express assignment of those rights.263 In the case of Avondale,264 a second-lien mortgage holder, MMA, signed a Subordination Agreement agreeing to be subrogated to the first-lien mortgage holder, National Bank, until the senior lien holder was paid in full. When the Debtor, Avondale, filed a plan of reorganization, MMA voted in favor of the plan, whereas National Bank cast two votes—one on behalf of itself and one on behalf of MMA under the subrogation agreement—to reject the plan. Avondale challenged National Bank’s right to vote on MMA’s behalf. The federal district court found in favor of National Bank, holding that a subrogor stands in the place of the subrogee with respect to a claim and holds all derivative rights of that claim, which includes voting rights.265

h. Surety’s Procedural Strategies in Bankruptcy Proceedings

(i) Motion to Appoint a Trustee or to Convert to a Chapter 7 Proceeding

Most Chapter 11 proceedings allow the debtor to retain possession of the bankruptcy estate throughout the proceedings. This may be harmful to the surety’s recovery in some circumstances, such as

262 Berens, supra note 215, at 13. 263 Wilbur F. Foster Jr., Abhilash M. Raval, & Peter K. Newman,

Contractual Subrogation in Bankruptcy and the Right to Vote, BUTTERWORTHS

J. OF INT’L BANKING & FIN. L. 460 (Sept. 2011). 264 In re Avondale Gateway Ctr. Entitlement, L.L.C., CV10-1772-PHX-

DGC, 2011 WL 1376997 (D. Ariz. 2011). 265 Id.

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where the debtor is using bonded funds for non-contract expenses. The surety does have the option to file a motion to have an independent trustee appointed to manage the estate or to convert the Chapter 11 proceeding to a Chapter 7 bankruptcy, which would also result in the appointment of a trustee.266 These motions require a showing of “cause” by the movant, however, and are not easily or often granted by the courts.267 The Bankruptcy Code allows such an appointment or conversion in the case of “fraud, dishonesty, incompetence, or gross mismanagement” or when it is in the interest of the creditors.268 Examples of debtor behavior short of actual fraud or embezzlement that can justify trustee appointment under the “best interest of the creditors” provision include “failure to pay post-petition taxes, failure to maintain insurance, commingling of personal and business assets, gross mismanagement, or an inability to reorganize the debtor.”269 The standards for conversion to a Chapter 7 proceeding slightly differ, setting out a non-exhaustive list of fourteen examples, including the continuing and likely permanent diminution of the estate.270 Although not always applicable, the motion to convert or appoint a trustee can be a useful tool for a surety to mitigate losses in situations where the debtor’s management of the estate is particularly egregious and harmful.

(ii) Withdrawal to District Court

In cases where the surety has a right to a jury trial, it should consider carefully before agreeing to the proceedings being conducted in bankruptcy court. The Bankruptcy Code requires the “express consent of all parties” for a jury trial to be heard before a bankruptcy judge.271 Thus, if the debtor or trustee has brought a proceeding in bankruptcy court for which there is a right to a jury trial, the surety has the option, depending on which forum it deems most favorable, to either allow the

266 11 U.S.C. § 1104(a); 11 U.S.C. § 1112(b). 267 Robert J. Berens & Tracey L. Haley, Bankruptcy: From the

Insurer’s Point of View, in HANDLING FIDELITY BOND CLAIMS, 2D ED. 661, 687 (Michael Keeley & Sean Duffy eds., 2005).

268 11 U.S.C. § 1104(a); 11 U.S.C. § 1112(b). 269 Berens & Haley, supra note 267, at 687. 270 11 U.S.C. § 1112(b). 271 28 U.S.C. § 157(e).

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proceeding to continue in bankruptcy court or file a motion to withdraw the reference, which transfers the proceeding to district court.272 In order to preserve this option, the surety must take care when submitting its Proof of Claim273 because filing the Proof of Claim in the bankruptcy court waives the right to a jury trial.274 Although the surety should take care to file its Proof of Claim before the deadline has passed, it may be advantageous to delay filing until the end of the deadline period to preserve its right to a jury trial.275

5. Conclusion

The filing for bankruptcy by a principal can lead to substantial losses for a surety. In order to protect itself, the surety should always monitor its principal’s financial condition and use of bonded contract funds and take steps to protect itself should either raise concerns. When a bankruptcy proceeding does occur, the insured should actively engage in the proceedings and evaluate the actions and defenses it has available and their applicability to the particular circumstances. Being proactive both before and after a bankruptcy filing can make a substantial difference in the surety’s losses resulting from a bankrupt principal.

VI. CONCLUSION

Effecting recovery based on an insurer or surety’s subrogation rights in specialized circumstances depends upon a myriad of factors: jurisdiction, contractual considerations, statutory considerations, whether the subrogation rights have been impaired, and whether bankruptcy proceedings are imminent or have been instituted. The insurer or the surety, along with local counsel familiar with the subrogation laws of the respective jurisdiction, needs to examine all these factors to make

272 28 U.S.C. § 157(d). 273 See discussion supra Part V, Section B, Subpart 4, Subsection e. 274 Berens & Haley, supra note 267, at 675; United States v. Leroy, 182

B.R. 827 (9th Cir. 1995); Ashley L. Belleau, Bankruptcy Nationwide Service: Does it Equate to Personal Jurisdiction, 52 FED. LAW. 2 (2005).

275 Berens & Haley, supra note 267, at 675.

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educated and informed decisions in order to successfully recover funds from the tortfeasor, the debtor, or the third party.

Documents

The Fidelity Law Journal... 236 Fidelity Law Journal, Vol. XVIII, November 2012 rights impaired by its insured. Part IV deals with procedural issues that may affect an insurer’s