A. Property of the Estate

At the time a debtor files a voluntary petition in bankruptcy an "estate" is created similar to a probate estate. The estate created consists of all property and interests of the debtor. Bankruptcy Code § 541 is titled "Property of the Estate" and defines in very broad language what is considered to be property within the bankruptcy estate. This section of the Bankruptcy Code includes as property of the bankruptcy estate almost every conceivable property interest of the debtor. Since fidelity policies are first party indemnity policies with the proceeds payable to the insured, a fidelity policy will likely be considered property of the bankruptcy estate.

B. Automatic Stay

Bankruptcy Code § 362(a) is aptly titled "Automatic Stay, and Section 362 has that exact meaning. Immediately upon filing the two page voluntary petition, all actions against the debtor and involving property of the bankruptcy estate are automatically stayed or enjoined from proceeding. The Automatic Stay prohibits virtually all collection activities or other acts that would improve a creditor's position against the debtor or the debtor's property. Actions taken in violation of the Automatic Stay are void. Moreover, actions taken that willfully violate· the Automatic Stay could lead to the imposition of an award of damages, and in appropriate circumstances an award of punitive damages.

Upon a bankruptcy filing, an insurer is prohibited from terminating or canceling an insurance policy, taking possession of the debtor's assets, obtaining a lien against the debtor's assets and/or perfecting a UCC security interest previously granted. The Automatic Stay prohibits further pursuit of all claims and actions against the debtor. A rule of thumb used by bankruptcy practitioners is "If it makes you smile, then it probably violates the Automatic Stay." As discussed later in this article, an insurer may file a motion in the bankruptcy court seeking relief from the Automatic Stay.

C. Various Bankruptcy Chapters

The types of bankruptcy filings in which a fidelity insurer most likely will be involved are Chapters 7. II and 13. A Chapter 7 case is referred to as a liquidation. A Chapter 7 trustee is appointed to liquidate property of the estate and distribute the proceeds to creditors on a pro rata basis.) The goal of most Chapter 7 debtors is to obtain a discharge of debts.

A Chapter 11 case is referred to as a reorganization. A reorganization occurs if a plan of reorganization is approved by the bankruptcy court.

As discussed below, a trustee may be appointed in a Chapter 11 case for "cause," or if it is in the best interests of creditors and the estate.

A Chapter 13 case is referred to as a statutory workout that enables individuals to restructure their debts by a court ordered repayment plan. An individual is permitted to file under Chapter 13 if their secured and unsecured debts are within the limits set in Code § 109(e). To confirm this Chapter 13 plan the debtor must apply his or her disposable income toward the repayment of debts for a period of between three and five years. Prior to enactment of The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Chapter 13 debtors received a "super discharge" which even discharged debts for fraud, embezzlement and breach of fiduciary duty.

D. Chapter 7 and Chapter 11 Trustees

Trustees are automatically appointed in a Chapter 7 case, and may be appointed by the bankruptcy court by filing a motion in a Chapter 11 case. Because the debtor is referred to as the "debtor-in-possession," it is uncommon for a trustee to be appointed in a Chapter II case, although the Code will allow for the appointment of a trustee in a Chapter 11 case. If appointed, the trustee handles all property of the estate, which would include claims against a fidelity insurer.

A trustee handling a claim may be easier to deal with than the debtor/claimant. The trustee has no emotional ties to the claim and may decide to settle a claim without passion or ulterior motives. However, the trustee's compensation is based upon the amount of distributions to creditors. Thus, it is obviously to the trustee's benefit to collect money for the estate. If the trustee perceives that the estate has a claim with high settlement value or a bankruptcy judge is predisposed towards the trustee's positions, the trustee may pursue the claim against the fidelity insurer oblivious to valid defenses. In such a situation, the chances of negotiation can become remote.

The trustee has no greater rights under a fidelity bond than the insured debtor. A trustee is not authorized to prosecute claims of the estate's creditors against third parties."! If the trustee asserts the claim, the trustee should be subject to the burdens the insured would have if it were prosecuting the claim. Regardless of who asserts the claim against the fidelity insurer, the claim should be no better or worse because of the bankruptcy case and the appointment of a trustee.

Another issue that may be applicable is whether the trustee has standing under a bond to pursue a claim for losses suffered by third parties. This issue relates to whether the insured corporate debtor has suffered a loss. Some bankruptcy courts have ruled in favor of the trustee, despite the fact that there was no "financial benefit" to employees or third parties, as defined in the bond. Other bankruptcy courts have rejected a trustee's claim for losses in a third party context." A fidelity insurer defending a suit filed by a bankruptcy trustee may consider having the action transferred to a court other than the district court, particularly if a jury trial would best serve the insurer's interests.

III. First Days After the Bankruptcy Filing

Upon learning that an insured or allegedly dishonest employee has filed for bankruptcy, certain actions should be immediately taken by the insurer.

A. Filing a Notice of Appearance and Request for Notice

The first thing to do immediately after becoming aware of a bankruptcy proceeding is to file a Notice of Appearance and Request for Notice in the newly-filed bankruptcy proceeding, with copies being sent to the debtor's counsel and to the United States Trustee's Office. This notice will notify debtor's counsel as to who represents the insurer. Additionally, the filing of the notice will result in the insurer's counsel being added to the master mailing list at the bankruptcy court for the bankruptcy case. Many notices in the bankruptcy proceeding, including the date, time, and place of the meeting of creditors, the deadline to file a proof of claim, the deadline to file a non-dischargeability action, and the deadline to object to a plan of reorganization, will be sent to the parties listed in the master mailing list.

B. Debtor's Disclosure of Financial Information

Debtors are required to file their Schedules and their Statement of Financial Affairs very soon after the bankruptcy filing. The 2005 Bankruptcy Act, amended Code § 521 to require the debtor to make additional disclosures of financial information. A debtor's failure to provide the requisite financial information within forty-five days of the bankruptcy filing, or within one additional forty-five day extension, will result in the automatic dismissal of the case. The Schedules include lists of the debtor's assets and liabilities, debtor's claimed exemptions, lists of creditors, and a schedule of current income and current expenditures. The Statement of Financial Affairs requires information on a multitude of financial questions. These required documents are generally filed by the debtor prior to the first meeting of creditors.

C. First Meeting of Creditors

The first meeting of creditors provides creditors an opportunity to assess various other creditors' positions in the case. This meeting also gives creditors an opportunity to ask the debtor or its representative a few questions under oath. For example, an insurer could ask about the genuineness of signatures on documents, where assets are currently located, the location of key witnesses, or precisely how the alleged loss occurred. The number of questions that each creditor can ask during the first meeting of creditors is limited. A full-blown examination may be taken, however, during what is referred to as a Rule 2004 examination, discussed in detail in Section V of this chapter.

D. Objection to Claimed Exemptions

Thirty days after the conclusion of the meeting of creditors, a creditor must file any objections to the exemptions claimed by the debtor. If the debtor amends the schedule on exemptions, then the deadline for filing an objection is extended thirty days after the date of such amendment. An extension can be requested, but the motion seeking the extension must be filed before the deadline to file an objection has passed. A creditor who fails to file a timely objection to the exemption claimed by the debtor will be deemed to have waived any right to claim that the property in question is property of the bankruptcy estate.

E. Filing a Proof of Claim

Generally, in a Chapter 7 or Chapter 13 case, a creditor has ninety days after the meeting of creditors to file a proof of claim. A proof of claim should contain the creditor's class of claim, namely whether the creditor has a secured priority unsecured claim or a non-priority unsecured claim. A secured claim is a claim that is partially or fully collateralized which class of claim is generally not applicable to insurers. Generally an insurer will also not have a priority unsecured claim. Example of these types of claims are for an individual's wages, contributions to an employee benefit plan and taxes. As a result, the insurer's claim may be categorized as a non-priority unsecured claim.

The more complicated issue is the amount of the fidelity insurer's claim. In many cases the insurer's claim will not be liquidated, yet the proof of claim must contain a liquidated amount for the insurer's claim. Two options are suggested. First, use the limits of the fidelity policy at issue as the amount of the insurer's claim. A proof of claim can be freely amended at a later date to reduce amount of the claim when the exact amount of the insurer's loss is known.-In the vast majority of cases the debtor or trustee will not object to the insurer's claim until much later in the case. In a Chapter 11 case, the bankruptcy court may temporarily allow a creditor's claim for purposes of the creditor voting to accept or reject a plan of reorganization. Another option is for the insurer to set the amount of its claim equal to the amount of loss it believes might be covered by its policy, assuming this is less than the policy limits.

The insurer should note that the filing of proof of claim waives the insurer's right to a jury trial. Waiver of a right to jury trial may cause an action against the insurer remaining in bankruptcy court, rather than being withdrawn to district court.

IV. Objecting to Discharge of Debt; Objecting to Debtor Obtaining a Discharge

The Bankruptcy Code provides for discharge of debts in Chapter 7, Chapter II, and Chapter 13 cases. In appropriate circumstances, the fidelity insurer may wish to contest the dischargeability of the debtor's debt to the insurer.

If the insurer has a legal basis for nondischargeability, then it may contest the discharge by filing a complaint to determine the nondischargeability of the debt owed to the insurer. The time limit for bringing a complaint under Code § 523(a) is relatively brief. In Chapter 7 and Chapter II cases, the complaint must be filed within sixty days following the date set for the first meeting of creditors.

An objection seeking nondischargeability of a particular debt under Code § 523(a) and/or seeking the denial of discharge being granted to a debtor under Code 727(a) must be brought by filing an adversary complaint. The standard of proof generally applicable to nondischargeability actions under Code 523(a) is preponderance of the evidence. The same standard of proof is applicable to actions under Code § 727(a).

If a final judgment was obtained prior to the bankruptcy filing date, and that judgment was based on fraud, breach of fiduciary duty, embezzlement or other misconduct, it may provide the insurer a basis to seek application of the doctrine of collateral estoppel in the bankruptcy court. As long as the creditor invokes collateral estoppel and demonstrates that its elements are satisfied, the bankruptcy court must apply collateral estoppel on an issue that was fully and fairly litigated in another court. Based thereon, care should be taken in preparing judgments so that they clearly provide that the judgment is based on fraud, breach of fiduciary duty or other claim provided for in Code § 523(a). This should enable the insurer to utilize the doctrine of collateral estoppel if a bankruptcy is subsequently filed.

The most common nondischargeability action filed by fidelity insurers is for fraud under Code § 523(a)(2), and for various bases under Code § 523(a)(4) for "fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny." Two grounds for nondischargeability of debt are set forth in Section 523(a)(2) of the Code. Generally, there are two different subsections of fraudulent conduct by the debtor that will render its liability to an insurer nondischargeable. Both subsections of conduct relate to the giving of false information of the creditor by the debtor. Under Section 523(a)(2)(A), it must be shown that the debtor employed "false pretences, a false representation, or actual fraud" to obtain the applicable insurance from the insurer. The United States Supreme Court has held that a debt will be nondischargeable under Section 523(a)(2)(A) if the creditor "justifiably relies," rather than "reasonably relies," on the debtor's fraudulent misrepresentations. Under Section 523(a)(2)B), it must be shown that the debtor provided a false financial statement to the insurer, with intent to deceive the insurer. The insurer, as the creditor objecting to dischargeability of debt, has the burden of proof under both subsections.

Section 523(a)(4) excepts from discharge any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. ... Thus, debts to fidelity insurers that arise as a result of the debtor's embezzlement or larceny of funds from an insured employer may be nondischargeable in bankruptcy. For example, in In re Shinew, an employee of a newspaper wrongfully appropriated $22,000 by manipulating the names of winners of contests run by the newspapers. The newspaper was insured by Liberty Mutual against losses resulting from employee fraud up to $10,000 and Liberty Mutual paid the full amount under the policy. The bankruptcy court held that the employee/debtor's $10,000 debt to Liberty Mutual was nondischargeable. Similarly, in In re Graziano, Great American Insurance Company had paid $50,000 to the debtor's employer under a fidelity bond. The bankruptcy court held the Great American's debt of $59,224.42, including expenses incurred in investigating and auditing the claim, was non-dischargeable.

Another basis to seek nondischargeability of a debt owed to the insurer is found in Code § 523(a)(3). The basis for nondischargeability under this section is that the creditor did not have notice or actual knowledge of the bankruptcy case in order to timely file a proof of claim and/or to timely file a nondischargeability action under Code § 523(a)(2, 4 or 6). The first notice the fidelity insurer may receive from the fidelity bond principal is the principal's assertion that the insurer's judgment has been discharged. It is not uncommon for fidelity claims representatives to first discover the bond principal's bankruptcy filing after the debtor received an order of discharge. If the insurer had a legitimate basis to seek nondischargeability of a debt under Code § 523(a)(2, 4 or 6) and the deadline to file such action has passed, then the insurer can file a complaint for nondischargeability of debt under Code § 523(a)(3)(B). If the insurer does not have a basis to seek nondischargeability of debt, but the deadline to file a proof of claim has passed, the insurer can file a complaint for nondischargeability under Code § 523(a)(3)(A). The fidelity insurer may need to file a motion to reopen the bankruptcy case to file its nondischargeability action based on Code § 523(a)(3).

Frequently confused with the complaint to determine nondischargeability of debt is the complaint objecting to the debtor's discharge under Section 727. The specific grounds to object to a debtor's discharge include, but are not limited to: (I) transferring, removing or destroying property with the intent to hinder, delay or defraud creditors, (2) the debtor concealing, destroying, mutilating or falsifying records, and (3) the debtor knowingly and fraudulently making a false oath in connection with the bankruptcy case. The deadline to file a complaint objecting to the debtor obtaining a discharge in a Chapter 7 case is sixty days after the first meeting of creditors. In a Chapter 11 case, the deadline to file the complaint objecting to discharge is the first date set for the hearing on confirmation of a plan of reorganization.('2 The successful objection to discharge under Section 727 will cause all debts, owed to all creditors, to survive the bankruptcy. In some cases, the showing of nondischargeability under Section 523 will also support the denial of discharge under Code § 727. From the insurer's standpoint, relief under Code § 523 is preferable because it results in only the debt to the insurer being excepted from discharge. This makes the debtor's postpetition assets, if any, subject to collection only by the insurer, rather than the entire group of creditors of the bankruptcy estate.

Where individuals have filed bankruptcies concurrently with a corporate debtor, the insurer may also file complaints to determine nondischargeability or objection to discharge in those individual bankruptcies. Even when there is little hope of immediate recovery from the individuals, there may be a strategic reason for filing the nondischargeability litigation. If the individuals have not been cooperative in the insurer's subrogation efforts or defense of claims, the possibility of survival of the insurer's claim may cause the individuals to be more helpful, and thus minimize the losses incurred by the insurer.

V. The Need for Information: Bankruptcy Rule 2004 Examination

In the early days and weeks of many bankruptcy cases, the need for information is critical. A party that has just filed bankruptcy, particularly a Chapter II case, is faced with many conflicting demands. Confronted with these burdens and deadlines, it is not unusual for the debtor to disregard a fidelity insurer's demand for information.

Fortunately, the Federal Rules of Bankruptcy Procedure provide an expedited method for an insurer to obtain information and documentation under these circumstances. Bankruptcy Rule 2004 authorizes an examination, similar to a deposition, where the debtor or its agents may be compelled to testify and to produce documentation. A major advantage of Bankruptcy Rule 2004 is that it does not require an insurer to commence litigation against the debtor before it may be used. An insurer can use this discovery tool to obtain documents and sworn testimony from the debtor, as well as third parties that may have relevant documentation and knowledge. Thus, the fidelity insurer has an important discovery tool that goes beyond compelling a sworn statement from the bond principal.

Bankruptcy Rule 2004 requires only that the insurer, requesting the issuance of an order for examination, file a motion. The order of the court under Bankruptcy Rule 2004 is sufficient to compel the attendance of the debtor at the examination. The scope of the Bankruptcy Rule 2004 examination is very broad, as the language of the rule would suggest. Thus, the insurer can use this rule to examine the debtor and various third parties with respect to any issues of importance to the insurer, including, but not limited to, aspects of fraudulent conduct and schemes, alter ego issues, and/or location of documents and collateral.

VI. Procedural Issues

It is not uncommon for a bankruptcy court to closely examine an action against an insurer when the action could bring monies into the bankruptcy estate. On that basis, defenses that should be held valid may fall on deaf ears. Thus, a fidelity insurer should consider procedural motions that transfer an action against the insurer from bankruptcy court to district court or state court.

A. Withdrawal of Bankruptcy Court Litigation to the District Court; When to File a Proof of Claim

Section 112 of the Bankruptcy Reform Act of 1994 clarified that bankruptcy judges may conduct jury trials if the following three conditions are satisfied: (I) the right to a jury trial applies; (2) the bankruptcy judge is specifically designated to conduct jury trials by the district court; and (3) all parties consent. Based on this provision, if a party has a right to a jury trial they may seek to have the proceedings transferred to district court by not consenting to the bankruptcy court conducting the jury trial. The motion seeking to withdraw the reference must be "timely." To be timely, the motion should be filed at the first reasonable opportunity. Thus, in a situation in which the trustee or debtor-in-possession has brought suit against the insurer in bankruptcy court, the insurer has the advantage of what might otherwise be considered "forum shopping," assuming it is entitled to a jury trial. If the insurer decides that the district court would be a better forum to conduct the jury trial, the case should be transferred to the district court merely by the insurer not consenting to the bankruptcy court conducting the jury trial.

It must be noted, however, that if a creditor files a Proof of Claim in the bankruptcy court, then the creditor waives its right to a jury trial. Therefore, if the insurer wants to retain its right to a jury trial, and thereby retain its right to have the litigation transferred to the district court, the insurer should wait as long as possible prior to filing a Proof of Claim. This may be contrary to current corporate policy. However, creditors are formally notified when they must file a Proof of Claim or have their claim barred in the bankruptcy case. In a Chapter 11 proceeding, a deadline to file claims is usually set by the bankruptcy court upon a specific motion asking for a bar date to be set. Creditors should not miss filing their claims on a timely basis if they want to be included in any pro rata distributions from the bankruptcy estate. The point is by delaying the filing of a Proof of Claim, the insurer may be able to have its jury trial held in district court and still participate as a creditor in any distributions from the bankruptcy estate.

B. Remanding Litigation Back to State Court

The insurer may be a defendant in a case originally filed in state court prior to any bankruptcy filing. Once the insured files for bankruptcy, the debtor may seek to withdraw the action to the bankruptcy court. Generally, if the debtor's action was not stayed by the Automatic Stay, then the debtor must remove the action to the bankruptcy court within ninety days after the bankruptcy filing.

The insurer may decide that the original forum in state court is preferable to the bankruptcy court. If so, the insurer may seek to remand the case back to the original state court. Factors that will enhance the insurer's chances of having the action remanded back to state court are: 1) whether state law claims are involved, 2) whether the action can be timely resolved in the original court, and 3) whether any bankruptcy issues are involved other than the claim is being asserted by the debtor in bankruptcy court.

C. Motion to Determine If Action Is Core or Non-Core Proceeding

Another procedural motion that should be considered is a motion seeking the bankruptcy court's determination whether an action is a "core" or "non-core" proceeding. This core versus non-core distinction is important for several reasons. First, the bankruptcy court may not enter final orders in non-core matters unless all parties consent. Thus, an insurer may obtain de novo review by the district court of any proposed findings of fact and conclusions of law issued by the bankruptcy court. Conversely, if the bankruptcy court determines that a matter is a core proceeding, then it can hear the matter and enter final orders thereon.

A basic list of core proceedings is set forth in 28 U.S.C. § 157(b)(2), and includes objections to discharge, preference and fraudulent conveyance litigation, objections to a plan of reorganization, allowance and disallowance of claims and more. The list of core proceedings set forth in 28 U.S.C. § 157(b)(2) is nonexclusive. The courts have been inconsistent in their determinations of similar matters being core or noncore proceedings.

D. Compelling Arbitration of a Dispute, If There Is a Valid Arbitration Agreement

The fidelity insurer may be involved in an action filed in bankruptcy court that is subject to an arbitration provision in a policy. If a valid arbitration clause is binding on the parties, then "the court shall make an order directing the parties to proceed to arbitration in accordance with the terms of the agreement." The Federal Arbitration Act applies to adversary proceedings in bankruptcy court If an action in bankruptcy court is subject to compulsory arbitration, the insurer should also consider filing a stay of the adversary proceeding pursuant to the Federal Arbitration Act, which provides that the "court in which the suit is pending.. . shall ... stay the trial of the action until such arbitration has been had in accordance with the terms of the agreement." If a valid arbitration clause is binding on the parties, then the bankruptcy court should stay non-core proceedings pursuant to the Federal Arbitration Act, but has more discretion to not stay a core proceeding.

VII. A Bankruptcy Filing May Toll Various Limitations Periods

A. The Bond Principal's Bankruptcy Filing Does Not Toll Any Limitations Periods

After an allegedly dishonest employee files for bankruptcy, the Automatic Stay provided for in Code § 362(a) prevents the commencement or continuation of lawsuits against him or her. To prevent a creditor from losing its claim due to expiration of a limitations period, the Bankruptcy Code contains tolling statutes that extend various limitations periods if the applicable time period did not expire prior to the bankruptcy filing. One tolling provision is Section I08(c), which extends the time "for commencing or continuing a civil action ... against the debtor" until the later of: (I) the end of such period and any suspensions thereof or (2) "30 days after notice of termination or expiration of the stay ... with respect to such claim." In other words, Code § I08(c) provides that, when applicable, non-bankruptcy law requires that a lawsuit be commenced against the debtor within a certain time period and a bankruptcy is filed prior to the time period running, then the time period to file suit is extended until at least thirty days after the Automatic Stay is terminated or expires.

The Bankruptcy Code's tolling statutes do not, however, toll or extend the period for institution of suit against the insurer. Several reported cases have held that the limitations period for bringing a fidelity claim or action against the insurer is not extended by a bankruptcy filing. Therefore, the tolling of the limitations period will not toll the time to bring suit against the insurer.

B. A Claimant's Bankruptcy Filing May Toll Various Limitations Periods

One of the key provisions in any fidelity bond pertains to discovery of loss. Under most crime policies, coverage does not exist unless the loss was "discovered" during the effective period or some set period of time subsequent to termination of the bond. Most commercial crime policies require that a claimant give notice of loss, provide a sworn proof of loss and commence litigation for recovery under the policy within a certain period of time after such discovery.

As discussed above, the Bankruptcy Code contains certain tolling provisions that extend various limitation periods if the applicable time period did not expire prior to the bankruptcy filing. Two tolling provisions are Code § 108(a), which extends the time "within which the debtor may commence an action," and Code § 108(b), which extends the time within which the debtor "may file any pleadings, demand, notice or proof of claim or loss, cure a default, or perform any other similar act," where such time period has not expired prior to the bankruptcy filing.

If applicable, Code § 108(a) tolls a limitations period for the debtor to commence an action, whether statutory or contractual, until the later of: (I) the end of such period and any suspensions thereof; or (2) "two years after the order for relief." If applicable, Code § I08(b) tolls a limitations period, whether statutory or contractual, until the later of: (I) the end of such period including any suspensions thereof; or (2) "60 days after the order for relief." The term "order for relief' for a voluntary bankruptcy means the date the bankruptcy petition was filed, and for an involuntary bankruptcy means the date the party against whom the involuntary petition was filed is adjudicated to be a "debtor." It is possible for litigation over the propriety of an involuntary bankruptcy filing to go on for several months, which will mean extension of time periods provided in Section 108(a) and (b) for an equivalent time period. Based on these tolling provisions, a fidelity bond claimant in bankruptcy may have additional months, and perhaps even an additional two years, in which to bring suit against the insurer's commercial crime policy or fidelity bond.

The time period to provide a notice of a claim or a sworn proof of loss may be extended by the Code's tolling provisions. The imp0l1ant point for the insurer is that there is the potential for dormant claims to "come out of the woodwork" in a claimant's bankruptcy. An insurer is well advised to investigate the possibility of "extended claims" prior to taking any detrimental actions based on the belief that claims are time barred.

VIII. Is the Wrongdoer the Alter Ego or Employee of the Bankrupt Insured?

An issue that may arise in a bankruptcy case is the "alter ego" defense and the issue of adverse domination. It has long been held that a fidelity policy does not insure an employer against his own fraud. Thus, a corporation cannot make a claim against a fidelity bond where the wrongdoer exercises such control over the corporation that he is the "alter ego" of the corporation. The Fifth Circuit described the alter ego defense as follows:

A corporation can only act through its officers and directors. When one person owns controlling interest in the corporation and dominates the corporation's actions, his acts are the corporation's acts. Allowing the corporation to recover for the owner's fraudulent or dishonest conduct would essentially allow the corporation to recover for its own fraudulent or dishonest acts. The bonds, however, were clearly designed to insure the corporations against their employee's dishonest acts and not their own dishonest acts.

The question presented by the alter ego defense is, therefore, whether the wrongdoer was an employee of the insured or, essentially, the insured itself. This question centers on the amount of control that the wrongdoer exercised over the corporation."1 The alter ego doctrine "does not require the piercing of the corporate veil, and it does not require total identity of shareholders, directors and officers."

On the flip side of the alter ego doctrine is the theory of adverse domination. Adverse domination in an equitable doctrine that operates to toll the statute of limitations for a corporation's claims against its officers or directors when those in charge of the corporation cannot be expected to pursue claims adverse to their own interests. In the fidelity insurance context, it has been applied to toll the time a corporation has to notify its insurer of employee theft. As one court explained, "where the culpable directors and officers control a corporation, they are unlikely to initiate actions or investigations for fear that such actions will reveal their own wrongdoing." Thus, the applicable time periods may be tolled during the period that the insured corporation is controlled by wrongdoers. However, insureds must walk a fine line here because if there is adverse domination, then the alter ego defense also might apply.

In the bankruptcy context, fidelity insurers who have a basis to assert an alter ego defense have had to contend with equitable arguments such as the adverse domination doctrine that may appeal to bankruptcy courts' inclination to bring money into the bankruptcy estate. Such arguments may also be appealing if a trustee brings the claim, rather than the owner/wrongdoer.

Perhaps the most egregious example of a bankruptcy court's application of the adverse domination doctrine to extend coverage beyond the limits of a policy is found in Shields National Union Fire Insurance Co. of Pittsburgh. PA (In re Lloyd Securities, Inc.). In that case, the trustee of an insured corporation's bankruptcy estate filed a complaint seeking to recover under a fidelity bond based on the fraudulent conduct of Michael Lloyd and Warren Nachman. Lloyd and Nachman were the sole officers of the debtor and the sole officers, directors and shareholders of the debtor's parent company, and their fraudulent activities included fraudulent misrepresentations on the bond applications in addition to wire fraud, mail fraud, bank fraud and conversion of union benefit plan funds. The bond defined employee as "an officer or other employee of the Insured, while employed in, at or by any of the Insured's offices or premises covered hereunder" or "any natural person who is a partial owner or partner of the Insured when such natural person is performing acts coming within the scope of the usual duties of an officer or employee of the Insured.,,98 Without discussion of the alter ego doctrine, the bankruptcy court found that Lloyd and Nachman were employees who were covered under the bond and the district court affirmed that finding.

The Second Circuit criticized the Lloyd Securities holding inn re Payroll Express Corp. 101 The debtor in Payroll Expressways owned by its president and CEO, Robert Felzenberg, and his wife, who, along with other officers of the corporation diverted corporate funds for their own benefit. The Second Circuit affirmed the district court's holding that the Felzenbergs were contractual alter egos of the debtor. The district court reasoned that because the Felzenbergs dominated and controlled the debtor, they could not be considered employees whose theft would be covered by the fidelity policy, The Second Circuit rejected the trustee's attempt to apply the adverse domination theory stating that the policies were void ab initio because Felzenberg had made material misrepresentations in the application. The court then criticized the Lloyd Securities court's extension of the adverse domination doctrine:

To the extent that the court in Lloyd Securities based its determination that the material misrepresentations on the fidelity bond application should not be imputed to the debtor corporation on the adverse domination doctrine, the decision was, at best, an extension of the doctrine well beyond its equitable tolling roots. Whereas the equitable tolling of statutes of limitations and other time periods only exposes the insurer to losses of a sort the insurer has already agreed to. absorb, extending this doctrine to the concealment of fraud in a policy application exposes the insurer to risks the insurer otherwise would not have assumed.

The essence of the alter ego doctrine as it applies in bankruptcy was well stated inn re Prime Commercial Corporation. In that case, the debtor's president and CEO, Patrick Wilson, who owned eighty percent of the outstanding stock in the debtor, engaged in several acts of theft. In holding that Wilson's acts were not covered by the policy because Wilson did not meet the policy's definition of an employee, the court provided the following summary of the issue:

Cases involving fidelity policies are not about balancing the rights of creditors with the interest of an insurer not to pay a thief. They are about interpretation of contracts of insurance. The contractual obligation of the Underwriters was to insure only those regular, paid employees of the business over whom Prime had "the right to govern and direct in the performance of such service." The issue is: did Prime control Wilson's performance?

IX. The Fidelity Policy As An Executory Contract

The Bankruptcy Code does not contain a definition of the term "executory contract." The legislative history and numerous courts have defined it as a contract “on which performance remains due to some extent on both sides." Some other courts have adopted a different method to determine whether a contract is "executory" under Code § 365, called the "functional approach. However, if the fidelity bond or commercial crime policy is fully terminated and all cure periods have lapsed prior to bankruptcy, it will not be an executory contract in a bankruptcy proceeding.

Under the Countryman definition, a fidelity bond or commercial crime policy may be considered an executory contract. However, inn re Government Securities Corp., the court held that the bond was not executory because the debtor had paid the premium in full prior to issuance of the bond. The only duty left for the insured was to comply with the claims procedure in the bond if a claim arose. The court did not view these duties as cause to classify the bond as an executory contract. The court distinguished other cases that held insurance policies as executory contracts based on on-going premium payments being required.

If the fidelity policy is an executory contract, it must be assumed very soon in a Chapter 7 case. The Chapter 7 trustee has sixty days from the date of the bankruptcy filing to assume (Le., accept) or reject the contract, or it is deemed rejected after the expiration of this sixty-day period. If the debtor has filed a Chapter 11 petition, the debtor-in possession can assume or reject an executory contract at any time prior to confirmation of a plan of reorganization.

To assume an executory contract, the debtor must show that the contract is executory in nature, that is, has not been terminated prior to the bankruptcy filing and it meets the Countryman definition. If the contract is executory and there have been defaults, pursuant to Code 365(b)( I), the debtor must promptly cure the defaults, and must demonstrate the ability to provide adequate assurance of future performance under the executory contract. Where there has been no default by the debtor, the debtor may assume an executory contract without satisfying the above tests.

The insurer can oppose assumption of the fidelity policy by asserting that the debtor is unable to meet the requirements of Code § 365(b)( I) for assumption because the debtor cannot promptly cure its defaults and/or cannot provide adequate assurance of future performance. Section 365(b)(l )(A) requires a "prompt" cure of any defaults prior to the assumption of a defaulted executory contract. To be "prompt," the cure must occur relatively quickly after assumption.

X. The Fidelity Insurer May Seek Relief from the Automatic Stay

A fidelity policy usually will be considered property of the bankruptcy estate and, therefore, protected by the Automatic Stay. For this reason, if the insurer has not terminated a fidelity bond or commercial crime policy prepetition, the bankruptcy filing of the bond principal may preclude the insurer from sending a notice of termination. If so, the insurer would have to seek and obtain relief from the Automatic Stay before terminating the fidelity policy or commercial crime policy.

A fidelity insurer that wants to terminate a policy post-petition should seek, under Code § 362(d)(l), to terminate the policy for "cause." In the context of a directors and officers liability policy, a court suggested that unstable corporate management and misrepresentations by the debtor's officers and directors may be the necessary "cause" to obtain relief from the Automatic Stay. If the fidelity bond is an executory contract, the "cause" as required under Code § 362(d)(l) for the Automatic Stay to be lifted, is the contract may not be assumable because the debtor cannot cure the existing defaults or because the debtor cannot provide adequate assurance of its future performance of the contract. The insurer should be prepared to show at a hearing that the contract is not assumable due to the debtor's financial inability to cure defaults or adequately assure future performance. These factors may establish the "cause" required under Section 362(d)(l) to obtain stay relief to terminate the fidelity policy or commercial crime policy.

XI. Motion to Appoint a Trustee or to Convert the Proceeding to Chapter 7

Ordinarily, a Chapter II debtor-in-possession will remain in possession of the bankruptcy estate throughout the Chapter 11 proceedings. But in certain cases, an insurer may wish to have the debtor's management displaced in favor of an independent trustee. This may be accomplished by the insurer making a motion to have an independent trustee appointed to manage the Chapter II case and/or to have the Chapter II case converted to a Chapter 7 proceeding.

Both appointment of a trustee and conversion are drastic actions by the bankruptcy court, and both require a substantial showing of "cause" by the movant. Section 1104(a) of the Bankruptcy Code allows for appointment of a trustee where there is some form of fraud or mismanagement or when the overall interests of the creditors will be served thereby. Evidence of embezzlement or intentional fraud will clearly support the appointment of a trustee. Other behavior that will permit the appointment of a trustee 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.

Conversion to a Chapter 7 proceeding, addressed in Section 1112(b) of the Code, will also result in the appointment of an independent trustee. The standard for cause that must be shown for conversion is slightly different than the standard for appointment of a trustee. Section 1112(b) sets forth certain non-exclusive examples of the cause that must be shown, including "continuing loss to or diminution of the estate" coupled with "absence of a reasonable likelihood of rehabilitation."

A surprisingly small percentage of cases commenced under Chapter II actually result in confirmed plans of reorganization. In most cases where the insurer is confronted with a debtor who is in bankruptcy and merely uncooperative, the time and expense attendant to a motion to appoint a trustee or to convert will not be justified. But, in an appropriate situation, these remedies under the Code can be successfully pursued by the insurer to supplant the principal's management and terminate unreasonable and economically wasteful behavior of the debtor.

XII. Recoupment and Setoff Defenses

Recoupment and setoff are distinct but related doctrines that may enable an unsecured or undersecured creditor to significantly reduce its loss in a bankruptcy case, and may have surprising applicability to the fidelity insurer in bankruptcy. The distinction between recoupment and setoff defenses, for bankruptcy purposes, is whether the debt and claim arose out of the same transaction or out of different transactions. In an adverse proceeding or contested matter in bankruptcy, the advantage to a creditor asserting recoupment defense, as opposed to the setoff defense, is the ability to recoup the debt against the debtor without first obtaining relief from the automatic stay and without establishing that the opposing obligations both "arose before the commencement of the case. These prerequisites to asserting a setoff defense are significant procedural and substantive hurdles.

XIII. The Bankruptcy Abuse Prevention and Consumer Protection Act

The 2005 Bankruptcy Act was enacted on April 20, 2005, but many of its provisions will not become effective until October 17, 2005. The 2005 Bankruptcy Act made substantial changes to the Bankruptcy Code that directly impact many issues the fidelity insurer will face in various bankruptcy proceedings. The scope of this chapter does not allow a complete review of all issues raised by the 2005 Bankruptcy Act. However, this section discusses certain select issues that are particularly important to the fidelity insurer.

There are new limits on a debtor filing serial and/or subsequent bankruptcy filings. A debtor receiving a discharge under Chapter 7 of the Code must now wait eight years rather than six years before they can qualify as a Chapter 7 debtor. A debtor cannot receive a discharge under Chapter 13 if they received a discharge under Chapter 7 or 11 for four years prior to filing for Chapter 13. A debtor cannot receive a discharge under Chapter 13 if they received a discharge in a prior Chapter 13 case within two years of their new case.

The Automatic Stay may be limited where a debtor has filed a case after an earlier case was dismissed. Depending on when the second or third bankruptcy case is filed, there are new provisions that the Automatic Stay does not become automatically effective, but rather the bankruptcy court may order a stay if the bankruptcy filing was made in good faith.

A commonly used defense to a preference action, under Code § 547(c)(2), is referred to as the ordinary course of business defense. Prior to enactment of the 2005 Bankruptcy Act, the creditor was required to prove that the challenged payment was both made in the ordinary course of business of both parties and was made according to ordinary business terms. With the 2005 amendments, the creditor can prove that the challenged transfer was either made in the ordinary course of business of both parties or was made according to ordinary business terms. 135 This amendment may aid a fidelity insurer's defense of a preference action for receipt of insurance premiums and possibly other payments received.

Chapter 7 debtors will have to qualify under an income "means" test before they can obtain a discharge. 136 If an individual does not meet the "means test" to qualify for a Chapter 7 discharge, the case can be dismissed, or with the consent of the debtor, converted to Chapter 11 or 13. The "means test" is a complicated formula that analyzes the debtor's monthly income as compared to the state median income. A debtor who fails to meet the "means test" is subject to dismissal.

A Chapter 13 debtor whose income exceeds the means test must file a Chapter 13 Plan that gives all "disposable income" to creditors for a period of five years, unless all unsecured creditors are paid in full in less than five years. Prior to the 2005 Bankruptcy Act the term of a Chapter 13 Plan had to be at least three years, but no more than five years.

An individual Chapter II debtor's post-petition income will now be included within the bankruptcy estate.

Before enactment of the 2005 Bankruptcy Act, an individual Chapter II debtor's post-petition income was not included within the bankruptcy estate. A strategy used by individual Chapter II debtors was to use only the cash they held prepetition to reorganize and not include post-petition monies in the plan. This enabled the debtor to amass their post-petition earnings during the Chapter II case and it was exempt property that belonged solely to the debtor. In a dispute over confirmation of a Chapter 11 plan of reorganization, these post-petition earnings were not included when analyzing the liquidation test under Code § I I29(a)(7), and these earnings did not have to be distributed to creditors on a pro-rata basis. The 2005 Bankruptcy Act has foreclosed this strategy for individual Chapter II debtors.

The 2005 Bankruptcy Act sets limits on homestead exemptions in bankruptcy cases. The amendments on homestead exemptions are set forth in Code § 522 and became effective immediately. For many debtors the homestead exemption cap will be $125,000. However, if a debtor acquired the homestead more than 1215 days prior to filing for bankruptcy or if it was a rollover of a previous homestead acquired in the same state, then the homestead may be higher depending on state law. 145 Prior to enactment of the 2005 Bankruptcy Act, debtors would move to states like Texas and Florida prepetition that had unlimited homestead exemptions. This strategy has been somewhat curtailed in the 2005 Bankruptcy Act.

The 2005 Bankruptcy Act permits debtors to claim the maximum amount of $1 million as exempt in their IRA account. This revision also became effective immediately. Prior to enactment of the 2005 Bankruptcy Act, some wealthy debtors, with the ability for longer range planning, would take much of their non-exempt assets, liquidate them, and make sizeable contributions to their IRA account. The 2005 Bankruptcy Act curtails this pre-bankruptcy planning strategy up to the amount of $1 million.

The "super discharge" that enabled Chapter 13 debtors to discharge claims based on fraud, embezzlement and breach of fiduciary duty will no longer be able to discharge these types of debt. Under the previous Code § 1328(a) claims for fraud, obtaining credit based on false financial statements, embezzlement, and breach of fiduciary duty were dischargeable by a Chapter 13 debtor. Under the 2005 Bankruptcy Act a Chapter 13 debtor will no longer be able to obtain a discharge of various types of debts set forth in Section 523(a).

XIV. Conclusion