Large businesses and organizations that self-insure their legally mandated insurance requirements often use “fronting” policies in which the policyholder must reimburse insurers for all losses and expenses paid on the policyholder’s behalf. These policyholders must furnish substantial collateral to secure repayment, typically, enough to pay many years’ worth of actual and anticipated claims. This can amount to hundreds of millions of dollars, and typically exacerbates cash flow and balance sheet problems for policyholders under financial stress. When a fronting policyholder enters bankruptcy, the disposition of the collateral – and the policyholder’s ability to maintain the required insurance to continue its operations – are often issues of primary and immediate importance in the bankruptcy proceeding.

Little precedential bankruptcy opinion exists to help bankruptcy and insurance litigators navigate these complex insurance arrangements. Recently, however, the Southern District of New York provided some guidance in the context of the Hostess bankruptcy (see In re Hostess Brands, Inc., Case No. 12-22052).

The Hostess Bankruptcy Left Key Issues Unresolved

Hostess maintained a fronting insurance program for its auto liability and workers’ compensation coverages. As part of its overall program, Hostess also was required to: (a) reimburse claims paid by the insurer within the deductibles; (b) provide approximately $120 million in cash, securities and letters of credit as collateral; and (c) reimburse the insurer on a monthly basis, for all within-deductible claims payments, which averaged $2.5 million per month, separate and apart from the collateral.

Through its “first day” insurance motion, Hostess obtained an order that confirmed the insurer’s first priority perfected security interests in and liens on the collateral, to be held by the insurer free and clear of any other parties’ liens, claims and encumbrances. The order also provided the insurer the right to apply the collateral to Hostess’ obligations under the insurance program. Finally, the order required Hostess to continue making post-petition deductible reimbursement payments of approximately $2.5 million per month, significantly impacting Hostess’ liquidity.

However, and as is frequently the case where a debtor self-insures through fronting policies, Hostess’ “first day” insurance motion left key issues unresolved, contributing to Hostess’ subsequent liquidity crisis and threatening its ability to effectively reorganize or conduct an orderly liquidation.

Hostess Prevails

As Hostess’ financial condition deteriorated, and believing that the insurer’s collateral requirements were out of line with its claims experience, Hostess retained an actuary to examine the claims history and to project future claims payments. Hostess’ actuary determined that the insurer was oversecured by approximately $30 million. Hostess requested a downward adjustment, but the insurer refused. Hostess sought the bankruptcy court’s intervention, filing a motion under section 363 of the Bankruptcy Code for an order authorizing Hostess to apply the collateral to Hostess’ ongoing deductible reimbursement obligation, effectively relieving Hostess of $2.5 million in monthly cash outlays.

Instead of opposing the motion, the insurer filed a separate motion to enforce an arbitration clause contained in the reimbursement and collateral agreements. The bankruptcy court denied that motion, holding that whether a debtor has authority to use cash collateral under section 363 of the Bankruptcy Code is “substantially core,” i.e., “central to the bankruptcy process” and thus not appropriate for arbitration outside of the bankruptcy court. The court further held that even if the arbitration clause clearly applied to the collateral dispute because the dispute is a core proceeding, it was within the court’s discretion to deny arbitration. Accordingly, the bankruptcy court declined the insurer’s request to compel arbitration.

Before resolving the underlying collateral motion, Hostess and the insurer agreed to a stipulated order (since approved by the court) essentially providing the relief originally sought by Hostess. Hostess will no longer make monthly deductible reimbursement payments; instead, the insurer will apply the collateral to the ongoing claims for which it would otherwise be entitled to reimbursement. The insurer and Hostess will revisit the collateral level annually, and if the insurer determines it is oversecured, it will return collateral to Hostess. If the insurer determines that it is undersecured, and Hostess agrees, the insurer is entitled to an administrative claim for the difference. If there is a dispute, the insurer can submit an administrative claim subject to a reservation of Hostess’ right to challenge the claim.

Conclusion

The Hostess decision teaches that bankruptcy and insurance practitioners must carefully examine the terms of fronting policies and the collateral and reimbursement agreements that almost always accompany fronting policies. While this outcome is of no precedential value, it serves as an example of how to resolve a complex insurance issue that often arises in bankruptcy.